U NITED S TATES S ECURITIES  AND E XCHANGE C OMMISSION


Washington,
      d.c. 20549




FORM
      10-KSB




**þ**
            **Annual
                Report of Small Business Issuers under Section 13 or 15(d) of the
                Securities Exchange Act of
                1934**




For
      the
      fiscal year ended June 30, 2006





or





** ̈**
            **Transition
                Report of Small Business Issuers under Section 13 or 15(d) of the
                Securities Exchange Act of
                1934**




For
      the
      transition period from __________ to ____________





Commission
      File No. 000-14247




**I** **SO** **R** **AY** **,
      I** **NC** **.**


(Exact
      name of registrant as specified in its charter)




Minnesota
              (State
                of incorporation)
            41-1458152
              (I.R.S.
                Employer Identification No.)350
                Hills St., Suite 106
              Richland,
                Washington 99354
              (Address
                of principal executive offices)
            (509)
                375-1202
              (Registrant’s
                telephone number)Issuer's
                telephone number, including area code:(509)
                375-1202Securities
                registered under Section 12 (b) of the Exchange Act - None
              
              Securities
                registered under Section 12(g) of the Exchange Act - Common Stock
                - $0.001
                par valueNumber
                of shares outstanding of each of the issuer's classes of common
                equity:Class
            Outstanding
                as of September 15, 2006Common
                stock, $0.001 par value
            15,802,394





Check
      whether the issuer is not required to file reports pursuant to Section 13 or
      15(d) of the Exchange Act. o




Check
      whether the issuer has (1) filed all reports required to be filed by Section
      13
      or 15(d) of the Exchange Act during the past 12 months (or for such shorter
      period the Company was required to file such reports), and (2) has been subject
      to such filing requirements for the past 90 days. Yes x No o




Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B contained in this form, and no disclosure will be contained,
      to
      the best of Company's knowledge, in definitive proxy or information statements
      incorporated by reference in Part III of this Form 10-KSB or any amendment
      to
      this Form 10-KSB. o




Indicate
      by check mark whether the Registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act):  Yes o No x




State
      issuer’s revenues for its most recent fiscal year - $1,994,306.




State
      the
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates computed by reference to the price at which the common equity
      was
      sold, or the average bid and asked prices of such common equity, as of a
      specified date within the past 60 days - $44,717,880 as of September 15,
      2006.




Documents
      incorporated by reference - none.




Transitional
      Small Business Disclosure Format : Yes o No x









**ISORAY,
      INC.**


**(formerly
      Century Park Pictures Corporation)**





**Table
      of Contents**





**Page**PART
                IItem
                1
            Description
                of Business
            
            1Item
                2
            Description
                of Property
            
            30Item
                3
            Legal
                Proceedings
            
            30Item
                4
            Submission
                of Matters to a Vote of Security Holders
            
            30PART
                IIItem
                5
            Market
                for Common Equity and Related Stockholders’ Matters
            
            30Item
                6
            Management's
                Discussion and Analysis
            
            32Item
                7
            Financial
                Statements
            
            40Item
                8
            Changes
                in and Disagreements with Accountants on Accounting and Financial
                Disclosures
            
            40Item
                8A
            Controls
                and Procedures
            
            41Item
                8B
            Other
                Information
            
            42PART
                IIIItem
                9
            Directors,
                Executive Officers, Promoters, and Control Persons; Compliance with
                Section 16(a) of the Exchange Act
            
            42Item
                10
            Executive
                Compensation
            
            48Item
                11
            Security
                Ownership of Certain Beneficial Owners and Management and Related
                Stockholder Matters
            
            50Item
                12
            Certain
                Relationships and Related Transactions
            
            51Item
                13
            Exhibits
                and Reports on Form 8-K
            
            53Item
                14
            Principal
                Accountant Fees and Services
            
            56SIGNATURES










**Caution
      Regarding Forward-Looking Information**





All
      statements contained in this Form 10-KSB, other than statements of historical
      facts, that address future activities, events or developments are
      forward-looking statements, including, but not limited to, statements containing
      the words “believe,” “anticipate,” “expect” and words of similar import. These
      statements are based on certain assumptions and analyses made by us in light
      of
      our experience and our assessment of historical trends, current conditions
      and
      expected future developments as well as other factors we believe are appropriate
      under the circumstances. However, whether actual results will conform to the
      expectations and predictions of management is subject to a number of risks
      and
      uncertainties described under “Risk Factors” beginning on page 22 below that may
      cause actual results to differ materially.




Consequently,
      all of the forward-looking statements made in this Form 10-KSB are qualified
      by
      these cautionary statements and there can be no assurance that the actual
      results anticipated by management will be realized or, even if substantially
      realized, that they will have the expected consequences to or effects on our
      business operations.





**PART
      I**





As
      used
      in this Form 10-KSB, unless the context requires otherwise, “we” or “us” or the
“Company” means IsoRay, Inc. and its subsidiary.





**ITEM
      1 - DESCRIPTION OF BUSINESS**




**General**




Century
      Park Pictures Corporation (“Century”) was organized under Minnesota law in 1983.
      Century had no operations since its fiscal year ended September 30, 1999 through
      June 30, 2005.




On
      July
      28, 2005, IsoRay Medical, Inc. (“Medical”) became a wholly-owned subsidiary of
      Century pursuant to a merger. Century changed its name to IsoRay, Inc. (“IsoRay”
or the “Company”). In the merger, the Medical stockholders received
      approximately 82% of the then outstanding securities of the Company.




Medical,
      a Delaware corporation, was incorporated effective June 15, 2004 to develop,
      manufacture and sell isotope-based medical products and devices for the
      treatment of cancer and other diseases. Medical is headquartered in Richland,
      Washington.





Medical
      was formed for the purpose of combining the operations of IsoRay, Inc. (a former
      Washington corporation) (“IsoRay (WA)”) and its subsidiary, IsoRay Products LLC,
      two companies that shared common ownership and management with Medical.
      Medical’s management initiated a merger transaction effective October 1, 2004,
      to combine operations.





**Business
      Operations**





**Certain
      Defined Terms**




The
      technical terms defined below are important to understand as they are used
      throughout this report and particularly in this discussion of the business
      of
      IsoRay. When used in this report, unless the context requires
      otherwise:




**“Brachytherapy”** refers
      to the process of placing therapeutic radiation sources in, or near, diseased
      tissue. Brachytherapy is derived from a Greek term meaning “short distance”
therapy.









**“Cesium-131”** ,  **“** **131** **Cs”** or **“Cs-131”** is an
      isotope of the element Cesium that gives off low energy, “soft” x-rays as it
      decays. Cesium-131 decays to 50% of its original activity every 9.7 days,
      becoming essentially inert after 100 days.




**“EBRT”** (external beam radiation therapy) is the external treatment of prostate cancer
      using an x-ray-like machine that targets a beam of radiation at the cancer
      site.
      The treatment damages genetic material within the cancer cells, which prevents
      the cells from growing and the affected cells eventually die. Treatments are
      generally performed at an outpatient center five days a week for seven or eight
      weeks.




**“Half-life”** means
      the time required for a radioisotope to decay to one-half of its previous
      activity. The amount of radiation emitted thus decreases to 25% of original
      activity in two half-lives, 12.5% in three half-lives, and so on.




**“Isotope”** refers
      to atoms of the same element that have different atomic masses. The word
“isotope” means “same place,” referring to the fact that isotopes of a given
      element have the same atomic number and hence occupy the same place in the
      Periodic Table of the Elements. Thus, they are very similar in their chemical
      behavior.




**“** **131** **Cs
      seed”** is the
      name by which IsoRay’s first product, the Cesium-131-based brachytherapy seed,
      is currently known.




**“Pure-beta
      particle emitter”** is a
      radioisotope whose only emissions during radioactive decay are beta particles
      (electrons). Beta particles can travel several millimeters in
      tissue.




**“RP”** (radical
      prostatectomy or prostatectomy) is the complete surgical removal of the
      prostate, under significant anesthesia. Two main types of surgery have evolved:
      nerve-sparing and non nerve-sparing. The nerve-sparing surgery is designed
      to
      minimize damage to the nerves that control penile erection.




**“Radiobiologic”** is
      characteristic of the effects of radiation on organisms or tissues, most
      commonly the effectiveness of therapeutic radiation in interrupting cell growth
      and replication.




**“Radioisotope”** is a
      natural or man-made isotope of an element that spontaneously decays while
      emitting ionizing radiation.




**“Seed”** is a
      common term for small radiation sources consisting of a radioisotope sealed
      within a biocompatible capsule such as gold or titanium, suitable for temporary
      or permanent brachytherapy implantation.




**“Therapeutic
      radiation”** refers
      to
      ionizing radiation with sufficient energy to disrupt basic biological processes
      of cells.




**Overview**





IsoRay
      intends to utilize its patented radioisotope technology, experienced chemists
      and engineers, and management team to create a major therapeutic medical isotope
      and medical device company with a goal of providing improved patient outcomes
      in
      the treatment of prostate cancer and other solid tumor cancers. IsoRay began
      production and sales of its Food and Drug Administration (“FDA”) cleared
      product, the IsoRay 131 Cs
      brachytherapy seed, in October 2004 for the treatment of prostate cancer.
      Management believes its technology will allow it to capture a leadership
      position in an expanded brachytherapy market. The more clinically beneficial
      characteristics of the Cesium-131 (Cs-131 or 131 Cs)
      isotope are expected to decrease radiation exposure to the patient and reduce
      the severity and duration of side effects, while treating cancer cells as
      effectively, if not more so than other isotopes used in seed brachytherapy.
      Cesium-131 could also enable meaningful penetration in other solid tumor
      applications such as breast, lung, liver, brain and pancreatic cancer, expanding
      the total available market opportunity.




2




Brachytherapy
      seeds are small devices used in an internal radiation therapy procedure. In
      recent years the procedure has become one of the primary treatments for prostate
      cancer and is now used more often than surgical removal of the prostate. The
      brachytherapy procedure places radioactive seeds as close as possible to (in
      or
      near) the cancer tumor (the word “brachytherapy” means close therapy). The seeds
      deliver therapeutic radiation by killing the tumor cells and cells located
      in
      the immediate vicinity of the tumor while minimizing exposure to adjacent
      healthy tissue. This allows doctors to administer a higher dose of radiation
      at
      one time than is possible with external beam radiation. Each seed contains
      a
      radioisotope sealed within a welded titanium capsule. Approximately 85 to 135
      seeds are permanently implanted in the prostate in a 45-minute outpatient
      procedure. The isotope decays over time and the seeds become inert. The seeds
      may be used as a primary treatment or, in conjunction with other treatment
      modalities such as external beam radiation therapy, chemotherapy, or as
      treatment for residual disease after excision of primary tumors.




Management
      believes that the IsoRay 131 Cs
      seed
      represents  the
      first
      major advancement in brachytherapy technology in over 18 years with attributes
      that could make it the long term “seed of choice” for internal radiation
      procedures. The 131 Cs
      seed
      has FDA approval for treatment of malignant disease (e.g. cancers of the head
      and neck, brain, liver, lung, breast, prostate, etc.) and may be used in
      surface, interstitial, and intracavity applications for tumors with known
      radiosensitivity.




The 131 Cs
      isotope appears to have specific advantages for treating cancer over Iodine-125
      (I-125 or 125 I)
      and
      Palladium-103 (Pd-103 or 103 Pd),
      the
      other isotopes commonly used in brachytherapy procedures. IsoRay believes that
      the short half-life and higher dose rate characteristics of 131 Cs
      will
      expand industry applications and facilitate meaningful penetration into the
      treatment of other forms of cancer such as breast cancer. The shorter half-life
      of 9.7 days for 131 Cs
      (versus 17 days for 103 Pd
      and 60
      days for 125 I)
      mitigates negative effects of long radiation periods on healthy tissue and
      is
      believed to reduce the duration of certain side effects. The higher initial
      dose
      rate is believed to be more effective on fast growing cancers by aggressively
      attacking cancer cells and disrupting cancer cell re-population cycles. The
      characteristics of 131 Cs  may
      result in the use of 10-30% fewer seeds per procedure compared to Pd-103,
      thereby reducing the total physical radiation dose to the patient and reducing
      the costs of the procedure for both third-party payers and the patient.





IsoRay
      and its predecessor companies have accomplished the following key milestones:




·
            Treated
                500th patient (September 2006);


·
            Opened
                a new manufacturing and production facility (October
                2005);


·
            Deployed
                a direct sales force to the market (July 2004 - July
                2005);


·
            Developed
                a treatment protocol for prostate cancer with a leading oncologist
                (January 2005);


·
            Treated
                the first patient (October 2004);


·
            Commenced
                production of the131Cs
                seed (August 2004);


·
            Filed
                five additional patent applications for the131Cs
                process (November 2003 - August
                2004);


·
            Obtained
                a Nuclear Regulatory Commission Sealed Source and Device Registration
                required by the Washington State Department of Health and the FDA
                (September 2004);


·
            Received
                a Radioactive Materials License from the Washington State Department
                of
                Health (July 2004);


·
            Implemented
                an ISO-9000 Quality Management System and production operating procedures
                (under continuing development);


·
            Signed
                a Commercial Work for Others Agreement between Battelle (manager
                of the
                Pacific Northwest National Laboratory or PNNL) and IsoRay, allowing
                initial production of seeds through 2006****at
                PNNL (April 2004);


·
            Raised
                over $23.0 M in debt and equity funding (September 2003 - August
                2006)


·
            Obtained
                favorable Medicare reimbursement codes for the Cs-131 brachytherapy
                seed
                (November 2003);


·
            Obtained
                FDA 510(k) approval to market the first product: the131Cs
                brachytherapy seed (March 2003);




3




·
            Completed
                initial radioactive seed production, design verification, computer
                modeling of the radiation profile, and actual dosimetric data compiled
                by
                the National Institute of Standards and Technology and PNNL (October
                2002); and


·
            Obtained
                initial patent for131Cs
                isotope separation and purification (May
                2000).




**Industry
      Information**




*Incidence
      of Prostate Cancer*




Excluding
      skin cancer, prostate cancer is the most common form of cancer, and the second
      leading cause of cancer deaths in men. The American Cancer Society estimated
      there will be about 234,460 new cases of prostate cancer diagnosed and an
      estimated 27,350 deaths associated with the disease in the United States during
      2006. Because of early detection techniques (e.g., screening for prostate
      specific antigen, or PSA) approximately 70% (164,100) of these cases are
      potentially treatable with seed brachytherapy, when the cancers are still
      locally confined within the prostate.





The
      prostate is a walnut-sized gland surrounding the male urethra, located below
      the
      bladder and adjacent to the rectum. The two most prevalent prostate diseases
      are
      benign prostatic hyperplasia (BPH) and prostate cancer. BPH is a non-cancerous
      enlargement of the innermost part of the prostate. Prostate cancer is a
      malignant tumor that begins most often in the periphery of the gland and, like
      other forms of cancer, may spread beyond the prostate to other parts of the
      body.





Prostate
      cancer incidence and mortality increase with age. Prostate cancer is found
      most
      often in men who are over the age of 50. More than seven out of ten men
      diagnosed with prostate cancer are over the age of 65. According to the American
      Cancer Society, approximately one man in six will be diagnosed with prostate
      cancer during his lifetime.




In
      addition to age, other risk factors are linked to prostate cancer, such as
      genetics. Men who have relatives that have been affected, especially if the
      relatives were young at the time of diagnosis, have an even higher risk of
      contracting the disease. Researchers have discovered that changes in certain
      genes, influenced by DNA mutations inherited from a parent, may cause some
      men
      to be more inclined to develop prostate cancer. It has also been suggested
      that
      environmental factors such as exposure to cancer-causing chemicals or radiation
      may cause DNA mutations in many organs. Another factor that may contribute
      to
      prostate cancer is diet, with diets high in fat and high in calcium possibly
      increasing the risk of prostate cancer.




The
      American Cancer Society recommends that men without symptoms, risk factors
      and
      who have a life expectancy of at least ten years, should begin regular annual
      medical exams at the age of 50, and believes that health care providers should
      offer as part of the exam the prostate-specific antigen (PSA) blood test and
      a
      digital rectal examination. The PSA blood test determines the amount of prostate
      specific antigen present in the blood. PSA is found in a protein secreted by
      the
      prostate, and elevated levels of PSA can be associated with either prostatitis
      (a noncancerous inflammatory condition) or a proliferation of cancer cells
      in
      the prostate. Transrectal ultrasound tests and biopsies are typically performed
      on patients with elevated PSA readings to confirm the existence of cancer.





A
      tumor
      found by a prostate biopsy is usually assigned a grade by a pathologist. The
      most common prostate cancer grading system is called the Gleason grading system.
      A Gleason score, which ranges from 2 to 10, usually is used to estimate the
      tumor’s growth rate. Typically, the lower the score, the slower the cancer
      grows. Most localized cancers of the prostate gland are associated with an
      intermediate score ranging from Gleason scores 4 through 6.





Staging
      is the process of determining how far the cancer has spread. The treatment
      and
      recovery outlook depend on the stage of the cancer. The TNM system is the
      staging process used most often. The TNM system describes the extent of the
      primary tumor (T stage), whether the cancer has spread to nearby lymph nodes
      (N
      stage), and the absence or presence of distant metastasis (M stage). The TNM
      descriptions can be grouped together with stages labeled 0 through IV (0-4).
      The
      higher the number, the further the cancer has spread. The following table
      summarizes the various stages of prostate cancer.




4




Stages
            
            Characteristics
                of Prostate CancerT1
                or T2
            
            Localized
                in the prostateT3
                or T4
            
            Locally
                advancedN+
                or M+
            
            Spread
                to pelvic lymph nodes (N+) or distant organs
                (M+)




*Treatment
      Options and Protocol*




In
      addition to brachytherapy, localized prostate cancer is commonly treated with
      radical prostatectomy (RP) and external beam radiation therapy (EBRT). Recently,
      intensity modulated radiation therapy (IMRT) has seen increased application,
      particularly in combination with brachytherapy for cancers that have begun
      to
      spread beyond the prostate. Other treatments include cryosurgery, hormone
      therapy, watchful waiting, and finasteride, a drug commonly prescribed to treat
      benign enlargement of the prostate and male baldness. Some of these therapies
      may be combined in special cases to address a specific cancer stage or patient
      need. When the cancerous tissue is not completely eliminated, the cancer
      typically returns to the primary site, often with metastases to other areas.





*Radical
      Prostatectomy.* Historically
      the most common treatment option for prostate cancer, radical prostatectomy
      is
      an invasive surgical procedure in which the entire prostate gland is removed.
      RP
      is performed under general anesthesia and typically involves a hospital stay
      of
      several days for patient observation and recovery. This procedure is often
      associated with relatively high rates of impotence and incontinence. For
      instance, a study published in the *Journal
      of the*  *American
      Medical Association* in
      January 2000 reported that approximately 60% of men who had received RP
      reported erectile dysfunction as a result of surgery. The same report found
      that
      approximately 40% of the patients studied reported at least occasional
      incontinence. New bilateral nerve-sparing techniques are currently being used
      more frequently in order to address these side effects, but these techniques
      require a high degree of surgical skill. RP is typically more expensive than
      other common treatment modalities.





*External
      Beam Radiation Therapy.* EBRT
      allows patients to receive treatment on an outpatient basis and at a lower
      cost
      than RP. EBRT involves directing a beam of radiation from outside the body
      at
      the prostate gland in order to destroy cancerous tissue. The course of treatment
      usually takes seven to eight weeks to deliver the total dose of radiation
      prescribed to kill the tumor. Studies have shown, however, that the ten-year
      disease free survival rates with treatment through EBRT are less than the
      disease free survival rates after RP or brachytherapy treatment. In addition,
      because the radiation beam travels through the body to reach the prostate,
      normal tissue lying in the path of the radiation beam is also damaged. Other
      side effects are associated with EBRT. For instance, rectal wall damage caused
      by the radiation beam is a noted negative side effect. Data suggests that
      between 30% and 40% of the patients who undergo EBRT suffer problems with
      erectile dysfunction after treatment.




*Intensity
      Modulated Radiation Therapy.* IMRT
      is a
      newer, more advanced form of EBRT in which sophisticated computer control is
      used to aim the beam at the target volume from multiple different angles and
      to
      vary the intensity of the beam. Thus, damage to normal tissue and critical
      structures is minimized by distributing the unwanted radiation over a larger
      geometric area. The course of treatment is similar to EBRT and requires daily
      doses over a period of seven to eight weeks to deliver the total dose of
      radiation prescribed to kill the tumor. IMRT is relatively new and thus not
      widely available for use as a treatment modality. As a result fewer clinical
      data regarding treatment effectiveness and the incidence of side effects are
      available. One advantage of IMRT, and to some extent EBRT, is the ability to
      treat cancers that have begun to spread from the tumor site. An increasingly
      popular therapy for patients with more advanced prostate cancer is a combination
      of IMRT with seed implant brachytherapy.





*Cryosurgery.* Cryosurgery,
      a procedure in which tissue is frozen to destroy tumors, is another treatment
      option for prostate cancer. Currently, this procedure is less widely used,
      although promising treatment outcomes have been reported. Cryosurgery typically
      requires a one to two day hospital stay and is associated with higher rates
      of
      impotence and other side effects than seed implant brachytherapy.




5




*Other
      Treatments.* Other
      treatments include hormone therapy and chemotherapy, which may be used to reduce
      the size of cancerous tumors. However, these treatments are not intended to
      ultimately cure a patient of prostate cancer. Instead, such treatment choices
      are made by physicians in an attempt to extend patients’ lives if the cancer has
      reached an advanced stage or as ancillary treatment methods used in conjunction
      with other treatment modalities. Common side effects of hormone therapy are
      impotence, decreased libido and breast enlargement. Common side effects of
      chemotherapy are nausea, hair loss and fatigue.





“Watchful
      waiting” or “active surveillance”, while not a treatment, is recommended by some
      physicians in extreme circumstances based on the severity and growth rate of
      the
      disease, as well as the age and life expectancy of the patient. Physicians
      and
      patients who choose watchful waiting are frequently seeking to avoid the
      negative side effects associated with RP or other treatment modalities. Through
      careful monitoring of PSA levels and close examination for advancing symptoms
      of
      prostate cancer, physicians may choose active treatments at a later
      date.





*Treatment
      Protocol.* Prostate
      cancer patients electing seed therapy first undergo an ultrasound test or CT
      scan, which generates a two-dimensional image of the prostate. With the
      assistance of a computer program, a three-dimensional treatment plan is created
      that calculates the number and placement of the seeds required for the best
      possible distribution of radiation to the prostate. Once the implant model
      has
      been constructed, the procedure is scheduled and the seeds are ordered. The
      number of seeds implanted normally ranges from 85 to 135, with the number of
      seeds varying with the size of the prostate. The procedure is usually performed
      under local anesthesia in an outpatient setting. The seeds are implanted using
      needles inserted into the prostate. When all seeds have been inserted, seed
      placement is verified through an ultrasound image, CT scan, fluoroscope or
      MRI.
      An experienced practitioner typically performs the procedure in approximately
      45
      minutes, with the patient normally returning home the same day. Most patients
      are able to return to their normal activities within one or two days following
      the procedure.





*Origin
      of Brachytherapy seeds*





One
      of
      the first reports in the medical literature regarding brachytherapy seeds that
      deliver “soft x-ray” radiation directly to tumors by permanent implantation
      appeared in 1965, authored by Donald C. Lawrence and Dr. Ulrich K.
      Henschke. Don Lawrence later developed and patented the titanium-encapsulated
      I-125 brachytherapy seed. His company, Lawrence Soft Ray Inc., provided the
      world’s supply of seeds from 1967 to 1978 until the 3M Corporation purchased the
      technology. Eventually 3M sold the business to Amersham PLC, which spun off
      this
      business to its division ONCURA, today the market leader in Iodine-125 seeds.
      All commercially available seeds trace their origin to Mr. Lawrence’s
      invention. Don Lawrence was a founder of IsoRay, LLC, the first predecessor
      company to IsoRay.





Brachytherapy
      has been used as a treatment for prostate cancer for more than 30 years.
      Formerly, seeds containing the radioactive isotope Iodine-125 were implanted
      in
      prostate tumors through open surgery. However, this technique fell into disfavor
      because the seeds were often haphazardly arranged resulting in radiation not
      reaching all of the targeted cancerous tissue. Compounding this was the fact
      that often an unintended radiation dose was delivered to healthy surrounding
      tissues, particularly the urethra and rectum. Originally, brachytherapy earned
      an unfavorable reputation because the early adopters did not have the imaging
      technologies needed for accurate placement of the seeds. This resulted in poor
      tumor control and greater damage to surrounding healthy tissue. Since the
      introduction of the ultrasound-guided, transperineal implantation technique
      in
      the late 1980s, brachytherapy has become a treatment that not only provides
      excellent therapeutic value but is very convenient and economical for the
      patient. The benefits of the advancements in imaging, computer dose planning,
      and the actual implant procedure have been validated by the improved clinical
      results achieved using modern brachytherapy techniques.




6




The
      introduction of Palladium-103 in the mid-1980s represented a major technology
      advancement in brachytherapy and played a significant role in the dramatic
      increase in the number of brachytherapy procedures performed. Within a
      relatively short period of time, 103 Pd
      captured 40% of the growing brachytherapy market.





Cesium-131  represents  the
      first
      major advancement in brachytherapy technology in over 18 years with attributes
      that management believes could make it the long term “seed of choice” for
      internal radiation procedures. Management believes that the 131 Cs
      seed
      has specific clinical advantages for treating cancer over 125 I
      and 103 Pd.





There
      is
      a large and growing potential market for the Company’s products. Several
      significant clinical and market factors are contributing to the increasing
      popularity of the brachytherapy procedure. In Europe brachytherapy is growing
      in
      excess of 25% per year and it is expected that market growth in the U.S. will
      also increase dramatically. In 1996 only 4% of prostate cancer cases were
      treated with brachytherapy, or about 8,000 procedures. In 2005, it was estimated
      that over 60,000 brachytherapy procedures were performed for prostate cancer.
      Brachytherapy as a treatment is now more common than radical prostatectomy
      and
      has become the treatment of choice for early-stage prostate cancer. Considerable
      attention is now being given to high risk and faster growing prostate cancers
      as
      well. Brachytherapy has significant advantages over competing treatments
      including lower cost, better survival data, fewer side effects, a faster
      recovery time and the convenience of a single outpatient procedure that
      generally lasts 45 minutes (Merrick, et al., *Techniques
      in Urology* ,
      Vol. 7,
      2001; Potters, et al., *Journal
      of Urology* ,
      May
      2005; Sharkey, et al., *Current
      Urology Reports* ,
      2002). ****





*Clinical
      Results*





Long
      term
      survival data are now available for brachytherapy with 103 Pd
      and 125 I,
      which
      support the efficacy of brachytherapy. Clinical data indicate that brachytherapy
      offers success rates for early-stage prostate cancer treatment that are equal
      to
      or better than those of RP or EBRT. While clinical studies of brachytherapy
      to
      date have focused on results from brachytherapy with Pd-103 and I-125,
      management believes that this data will be relevant for brachytherapy with
      Cs-131, and Cs-131 may offer improved clinical outcomes over Pd-103 and I-125,
      given its shorter half-life and higher energy.





*Improved
      patient outcomes.* A number
      of published studies on the use of 103 Pd
      and 125 I
      brachytherapy in the treatment of early-stage prostate cancer have been very
      positive (we have not obtained consents to cite the studies listed
      below).





·
            In
                September 2006 a 5 year prospective study to assess the impact of
                interstitial brachytherapy on the quality of life of patients with
                localized prostate cancer was published. The results of the present
                study
                confirm that the impact of interstitial brachytherapy on the patients’
                quality of life is low despite its transient negative effects on
                some
                function, and extend existing knowledge concerning quality of life
                after
                interstitial brachytherapy.*International
                Journal of Radiation Oncology; Volume 66;
                1;31-37.*


·
            Atwelve-year
                clinical study published in the 2004 Supplement of the*International
                Journal of Radiation Oncology, Biology and Physics*,
                reported relative survival rate of 84% for low risk cancer patients,
                78%
                for intermediate risk cancer patients and 68% for high risk cancer
                patients. The study was conducted by Dr. Lou Potters, et al. of the
                New York Prostate Institute and included 1,504 patients treated with
                brachytherapy between 1992 and
                2000.


·
            A
                study published in the January 2004 issue of the*International
                Journal of Radiation Oncology, Biology and Physics*,
                reported that brachytherapy, radical prostatectomy, high-dose external
                beam radiation therapy and combined therapies produced similar cure
                rates.
                The study was conducted by Dr. Patrick Kupelian, Dr. Louis
                Potters, et al. and included 2,991 patients with Stage T1 or T2
                prostate cancer. Of these patients, 35% of patients underwent surgery,
                16%
                received low-dose EBRT, 10% received high-dose EBRT, 7% received
                combination therapy and 32% received brachytherapy. After five years,
                the
                biochemical relapse-free survival rate was 83% for brachytherapy,
                81% for
                radical prostatectomy, 81% for high-dose EBRT, 77% for combination
                therapy
                and 51% for low-dose EBRT.




7




·
            A
                nine-year clinical study published in the March 2000 issue of the*International
                Journal of Radiation Oncology, Biology and Physics*,
                reported that 83.5% of patients treated with Pd-103 seeds were cancer-free
                at nine years. The study was conducted by Dr. John Blasko of the
                Seattle Prostate Institute and included 230 patients with clinical
                stage
                T1 and T2 prostate cancer. Only 3% experienced cancer recurrence
                in the
                prostate.


·
            Results
                from a 10-year study conducted by Dr. Datolli and Dr. Wallner
                published in the*International
                Journal of Radiation Oncology, Biology and Physics*in
                September 2002, were presented at the October 2002 American Society
                for
                Therapeutic Radiology and Oncology (ASTRO) conference confirming
                the
                effectiveness of the Pd-103 seed in patients with aggressive cancer
                who
                previously were considered poor candidates for brachytherapy. The
                10-year
                study was comprised of 175 patients with Stage T2-T3 prostate cancer
                treated from 1991 through 1995. Of these patients, 79 percent remained
                completely free of cancer without the use of hormonal therapy or
                chemotherapy.


·
            A
                study by the Northwest Prostate Institute in Seattle, Washington
                reported
                79% disease-free survival at 12 years for brachytherapy in combination
                with external beam radiation (Ragde,*et
                al*.,*Cancer,*July 2000). The chance of cure from brachytherapy is nearly 50%
                higher than for other therapies for men with large cancers (PSA 10-20)
                and
                over twice as high as other therapies for men with the largest cancers
                (PSA 20+) (K. Wallner,*Prostate
                Cancer: A Non-Surgical Perspective,*Smart Medicine Press, 2000).




*Reduced
      Incidence of Side Effects.* Sexual
      potency and urinary incontinence are two major concerns men face when choosing
      among various forms of treatment for prostate cancer. Because the IsoRay 131 Cs
      seed
      delivers a highly concentrated and confined dose of radiation directly to the
      prostate, healthy surrounding tissues and organs typically experience less
      radiation exposure. Management believes, and initial results appear to support,
      that this should result in lower incidence of side effects and complications
      than may be incurred with other conventional therapies, and when side effects
      do
      occur, they should resolve more rapidly than those experienced with I-125 and
      Pd-103 isotopes.




*Favorable
      Market Factors*




*Lower
      Treatment Cost* .
      The
      total one-time cost of brachytherapy ranges from $10,000 to $17,000 per
      procedure. This is less than the cost of a radical prostatectomy or RP, which
      ranges from $17,000 to $20,000, excluding treatment for side effects and
      post-operative complications. Brachytherapy cost is comparable to the cost
      of
      EBRT (external beam radiation), which is approximately $14,000 to $35,000 for
      a
      seven to nine week course of treatment.




*Favorable
      Demographics* .
      Prostate cancer incidence and mortality increase with age. Prostate cancer
      is
      found most often in men who are over the age of 50. The National Cancer
      Institute has reported that the incidence of prostate cancer increases
      dramatically in men over the age of 55. Currently, one out of every six men
      is
      at lifetime risk of developing prostate cancer. More than seven out of ten
      men
      diagnosed with prostate cancer are over the age of 65. At the age of 70, the
      chance of having prostate cancer is 12 times greater than at age 50. According
      to the American Cancer Society, prostate cancer incidence rates increased
      between 1988 and 1992 due to earlier diagnosis in men who otherwise had no
      sign
      of symptoms. Early screening has fostered a decline in the prostate cancer
      death
      rate since 1990.





The
      number of prostate cancer cases in the U.S. is expected to increase due to
      the
      expanding population of men over the age of 55. The U.S. Census Bureau estimates
      this segment of the population will increase from 25.9 million men in 2000
      to 32
      million men by 2008 - a 24% increase. Extrapolating that data, management
      believes that the U.S. will provide over 180,000 candidates annually for
      prostate brachytherapy by 2008.




*Increased
      PSA Screening* .
      Early
      PSA screening and testing leads to early diagnosis. The American Cancer Society
      recommends that men without symptoms or risk factors and who have a life
      expectancy of at least ten years, should begin regular annual medical exams
      at
      the age of 50, and believes that health care providers should offer as part
      of
      the exam the prostate-specific antigen blood test. The PSA blood test determines
      the amount of prostate specific antigen present in the blood. PSA is found
      in a
      protein secreted by the prostate, and elevated levels of PSA can be associated
      with either prostatitis (a noncancerous inflammatory condition) or a
      proliferation of cancer cells in the prostate. Industry studies have shown
      that
      the PSA test can detect prostate cancer up to five years earlier than the
      digital rectal exam. Ultrasound tests and biopsies are typically performed
      on
      patients with elevated PSA readings to confirm the existence of cancer.




8




**Our
      Strategy**




The
      key
      elements of IsoRay’s strategy include:





·
            *Continue
                to introduce the IsoRay**131**Cs
                seed into the U.S. brachytherapy market*.
                Utilizing a direct sales organization and selected channel partners,
                IsoRay intends to capture a leadership position by expanding overall
                use
                of the brachytherapy procedure for prostate cancer, capturing much
                of the
                incremental market growth and taking market share from existing
                competitors.


·
            *Create
                a state-of-the-art manufacturing process*.
                IsoRay has constructed a state-of-the-art manufacturing facility
                in
                Richland, Washington in its newly leased facility, to implement our
                proprietary manufacturing process which is designed to improve profit
                margins and provide adequate manufacturing capacity to support future
                growth and ensure quality control. If Initiative 297 presents a strategic
                roadblock to the Company, IsoRay plans to construct a permanent
                manufacturing facility in another state. Working with leading scientists,
                IsoRay intends to design and create a proprietary separation process
                to
                manufacture enriched barium, a key source material for131Cs,
                to ensure adequate supply and greater manufacturing efficiencies.


·
            *Introduce
                Cesium-131 therapies for other cancers*.
                IsoRay intends to partner with other companies to develop the appropriate
                delivery technology and therapeutic delivery systems for treatment
                of
                other solid tumors such as breast, lung, liver, pancreas, neck, and
                brain
                cancer. IsoRay’s management believes that the first major opportunities
                may be for the use of Cesium-131 in adjunct therapy for the treatment
                of
                residual lung and breast cancers.


·
            *Support
                clinical research and sustained product development*.
                The Company plans to structure and support clinical studies on the
                therapeutic benefits of Cs-131 for the treatment of solid tumors
                and other
                patient benefits. We are and will continue to support clinical studies
                with several leading radiation oncologists to clinically document
                patient
                outcomes, provide support for our product claims and compare the
                performance of our seeds to competing seeds. IsoRay plans to sustain
                long-term growth by implementing research and development programs
                with
                leading medical institutions in the U.S. to identify and develop
                other
                applications for IsoRay’s core radioisotope
                technology.




Management
      believes there is a large and growing addressable market for IsoRay’s products.
      Several factors appear to contribute to the increasing popularity of the
      brachytherapy procedure. Long-term survival data are now available for
      brachytherapy (other than with respect to treatment from Cs-131 seeds).
      Brachytherapy has become the treatment of choice for not only early-stage
      prostate cancer but is now being considered for treatment of fast growing,
      aggressive tumors. For the treatment of prostate cancer, seed brachytherapy
      is
      now more common than surgery (radical prostatectomy). Seed brachytherapy has
      significant advantages over competing treatments including lower cost, better
      survival data, fewer side effects, a faster recovery time and the convenience
      of
      an outpatient procedure that generally lasts 45 minutes. Over 60,000 procedures
      were forecasted to occur in the U.S. in 2005. At the June 30, 2006 Cs-131 seed
      price of $55, this represents a potential $330 million market for seeds that
      is
      forecast to grow substantially by 2009 according to a recent market survey
      performed by Frost & Sullivan, a nationally recognized market research firm.
      IsoRay’s management believes that the 131 Cs
      seed
      will add incremental growth to the existing brachytherapy seed market as
      physicians who are currently reluctant to recommend brachytherapy for their
      prostate patients due, in part, to side effects caused by longer-lived isotopes,
      become comfortable with the shorter half-life of 131 Cs,
      and
      the anticipated reduction of side effects.




9




**Products**





IsoRay
      markets the Cesium-131  seed
      and
      intends to market other radioactive isotopes in the future. Additionally, it
      will attempt to create a market, primarily in clinical trials, for the liquid
      Cs-131 isotope, which is created in the production of IsoRay’s 131 Cs
      seed.





*Cs-131
      Seed Product Description and Use in Cancer Treatment*





Brachytherapy
      seeds are small devices that deliver therapeutic radiation directly to tumors.
      Each seed contains a radioisotope sealed within a welded titanium capsule.
      In
      prostate cancer procedures, approximately 85 to 135 seeds are permanently
      implanted in a 45-minute outpatient procedure. The isotope decays over time,
      and
      the seeds become inert. The seeds may be used as a primary treatment or in
      conjunction with other treatment modalities such as external beam radiation
      therapy, chemotherapy, or as treatment for residual disease after excision
      of
      primary tumors.





Significant
      advantages of brachytherapy over competing treatments include: fewer side
      effects (the likelihood of impotence and incontinence is reduced when seeds
      are
      used to treat prostate cancer); short, convenient outpatient procedure
      (typically 45 minutes); faster recovery time (days vs. weeks); lower cost than
      other treatment modalities; higher cure rates for solid tumors; less pain;
      and
      overall considerably better quality of life. The primary disadvantage of
      brachytherapy is subjecting the human body to radiation and the side effects
      of
      radiation. Physician errors in seed placement and the number of seeds implanted
      may also result in the failure to eradicate the cancer or in negative side
      effects from over-radiation of certain tissues in the body.





A
      diagram
      of the IsoRay seed appears in Figure 1. The seed contains an x-ray opaque marker
      surrounded by a ceramic substrate to which the isotope is chemically attached.
      The seed core is placed in a titanium tube and precision laser welded to form
      a
      hermetically sealed source of therapeutic radiation suitable for permanent
      implantation. The x-ray marker allows the physician to accurately determine
      seed
      placement within the tumor.










*Figure
      1: Cross section of* *131* *Cs
      seed*





*Competitive
      Advantages of Cs-131*





Management
      believes that 131 Cs
      has
      specific clinical advantages for treating cancer over I-125 and Pd-103, the
      other isotopes currently used in brachytherapy seeds. The table below highlights
      the key differences of the three seeds. The Company believes that the short
      half-life, high-energy characteristics of 131 Cs
      will
      increase industry growth and facilitate meaningful penetration into the
      treatment of other forms of cancer such as breast cancer.





10





**Brachytherapy
      Isotope Comparison**





**Cesium-131**
            
            **Palladium-103**
            
            **Iodine-125****Half
                Life**
            
            9.7
                Days
            
            17.5
                days
            
            60
                days**Avg.
                Energy**
            
            30.4
                KeV+
            
            21
                KeV+
            
            28.5
                KeV+**Dose
                Delivery**
            
            90%
                in 33 days
            
            90%
                in 58 days
            
            90%
                in 204 days**Total
                Dose**
            
            115
                Gy
            
            125
                Gy
            
            145
                Gy**Anisotropy
                Factor*******
            
            .969
            
            .877
                (TheraSeed® 2000)
            
            .930
                (OncoSeed® 6711)


* Degree
        of
        symmetry of therapeutic dose, a factor of 1.00 indicates symmetry. ****
 + KeV
        =
        kiloelectron volt, a standard unit of measurement for electrical
        energy.




*Shorter
      half-life* . ** The
      Company believes that Cesium-131’s shorter half-life of 9.7 days will prove to
      have greater biological effectiveness, will mitigate the negative effects of
      long radiation periods on healthy tissue and will reduce the duration of any
      side effects. A shorter half-life produces more intense therapeutic radiation
      over a shorter period of time and may reduce the potential for cancer cell
      survival and tumor recurrence. Radiobiological studies indicate that
      shorter-lived isotopes are more effective against faster growing tumors (Dicker,
      et. al., *Semin.
      Urol. Onc.* 18:2,
      May 2000). Other researchers conclude that “half-lives in the approximate range
      4-17 days are likely to be significantly better for a wide range of tumor types
      for which the radiobiologic characteristics may not be precisely known in
      advance.” (Armpilia CI, et. al., *Int.
      J. Rad. Oncol. Biol. Phys.* 55:2,
      February 2003).




*Higher
      energy* .
      The
      Cs-131 isotope average decay energy of 30.4 KeV (versus 21 KeV for Pd-103 and
      28.5 KeV for I-125) generates a therapeutic radiation field that extends beyond
      the current dosimetry reference point of 1 cm. Pd-103 seeds emit radiation
      that
      does not penetrate as far in tissue (up to 40% lower than Cs-131). To compensate
      for this more Pd-103 seeds are required to attain the equivalent dose as if
      Cs-131 seeds were used. This increase in the number of seeds implanted increases
      the time and cost required to perform Pd-103-based procedures. The lower energy
      from 103 Pd
      seeds
      may also result in greater non-uniformity of the implant dose as dose rates
      near
      the surface of each seed must be higher to compensate for lower doses at greater
      distances from each seed. The high energy of Cs-131 can result in radiation
      toxicity if the dosage is not properly calculated by the implanting physician
      and staff but the higher energy of Cs-131 does make the isotope more “forgiving”
for treatment planning purposes.




*Reduced
      side effects* . ** Because
      the IsoRay 131 Cs
      seed
      device delivers a highly concentrated and confined dose of radiation directly
      to
      the prostate, healthy surrounding tissues and organs are exposed to less
      radiation than with other treatments. Management believes this should result
      in
      fewer and less severe side effects and complications than may be incurred with
      other conventional therapies.










*Figure
      2: Cs-131 seed Autoradiograph*





*Shape
      of radiation field* . ** The
      shape
      of the radiation field generated by a 131 Cs
      seed
      is more uniform than most brachytherapy seed designs, and this uniformity may
      result in better radiation dose coverage and improved therapeutic effectiveness.
      Figure 2 shows an autoradiograph (film exposed by radiation from the seed
      itself) of an IsoRay seed, which shows this uniformity of the radiation field
      that is expected to result in better radiation dose coverage. IsoRay has
      conducted extensive computer modeling and testing of the seed design. The IsoRay
      seed has passed all Nuclear Regulatory Commission (“NRC”) requirements for
      sealed radioactive sources. Dose uniformity was tested and the results compared
      well to those predicted by industry standard computer modeling techniques.
      In
      the third quarter of 2002, seeds were sent to the National Institute for
      Standards and Technology for calibration, and have undergone dosimetry testing
      according to American Association of Physicists in Medicine (“AAPM”) protocols.
      The results of these tests were compiled in IsoRay’s 510(k) submission to the
      FDA and were subsequently published in the June 2004 issue of *Medical
      Physics* .
      The
      results of these tests showed superior dose characteristics relative to the
      leading I-125 and Pd-103 seeds.




11




*Reduced
      costs* .
      The
      characteristics of 131 Cs
      seeds
      described above may result in the use of 10%-30% less seeds per procedure,
      compared to other isotopes, thereby reducing the total physical radiation dose
      to the patient and reducing the costs of the procedure for the third-party
      payers and the patient.





**Yttrium
      90**





Since
      formation of the Company, management had intended to introduce a second product,
      Yttrium 90, sometime in 2006. However, management now intends to focus all
      of
      its efforts on manufacturing and marketing Cs-131 as it now believes that
      Yttrium 90 will require far too much capital and distract management from its
      core business at a time when it believes it can gain valuable market share
      for
      Cs-131.





**Cs-131
      Manufacturing Process**





Cs-131
      is
      a radioactive isotope that can be produced by the neutron bombardment of
      Barium-130. When Ba-130 is put into a nuclear reactor it becomes Ba-131, the
      radioactive material that is the parent isotope of Cs-131. The overall process
      includes the following:





·
            *Isotope
                Generation*.****The
                radioactive isotope Cs-131 is normally produced by placing a quantity
                of
                stable non-radioactive barium (ideally pure Ba-130) into the neutron
                flux
                of a nuclear reactor. The irradiation process converts a small fraction
                of
                this material into a radioactive form of barium (Ba-131). The Ba-131
                decays by electron capture to the radioactive isotope of interest
                (Cs-131). Due to the short half-life of both the Ba-131 and Cs-131
                isotopes, potential suppliers must be capable of removing irradiated
                materials from the reactor core on a routine basis for subsequent
                processing to produce ultra-pure Cs-131. The Company has identified
                more
                than five reactor facilities in the U.S., Europe and the former Soviet
                Union that are capable of meeting these requirements. As of the date
                of
                this report, IsoRay has agreements in place with two suppliers of
                irradiated Ba-131 or Cs-131. The Company’s agreement with Russia’s
                Institute of Nuclear Materials (which commenced as of August 25,
                2005 and
                ends August 25, 2012) allows the Company to purchase irradiated Ba-131
                for
                $300.00 per Curie of the isotope. The projected value of the agreement
                over its term is $30,000,000 with $300,000 worth of isotope projected
                to
                be delivered in the first full year of production, although neither
                of
                these amounts are obligations to purchase any given quantity of the
                isotopes in a particular time period. Through June 30, 2006, the
                Company
                had paid approximately $74,000 to the Institute of Nuclear Materials.
                In
                addition, the Company is engaged in the development of a barium enrichment
                device that, if successful, should reduce the cost of producing Cs-131
                while maintaining the purity and consistency required in the end
                product.


·
            *Isotope
                Separation and Purification*.****Upon
                irradiation of the barium feedstock, the Ba-131 begins decaying to
                Cs-131.
                At pre-determined intervals the Cs-131 produced is separated from
                the
                barium feedstock and purified using a proprietary radiochemical
                separations process (patent applied for). Due to the high-energy
                decay of
                Ba-131, this process is performed under stringent radiological controls
                in
                a highly shielded isolator or “hot cell” using remote manipulators. After
                separating Cs-131 from the energetic Ba-131, subsequent seed processing
                may be performed in locally shielded fume hoods or glove boxes. If
                enriched barium feedstock is used, the residual barium remaining
                after
                subsequent Cs-131 separation cycles (“milkings”) will be recycled back to
                the reactor facility for re-irradiation. This material will be recycled
                as
                many times as economically feasible, which should make the process
                more
                cost effective. As an alternative to performing the Cs-131 separation
                in
                our own facilities, IsoRay may enter into agreements with other entities
                to supply “raw” Cs-131 by performing the initial barium/cesium separation
                at their facilities, followed by final purification at IsoRay’s
                facility.




12




·
            *Internal
                Seed Core Technology*.****The
                purified Cs-131 isotope is incorporated into an internal assembly
                that
                contains a binder, spacer and a gold X-ray marker. This internal
                core
                assembly is subsequently inserted into a titanium case. The dimensional
                tolerance for each material is extremely important. Several carrier
                materials and placement methods have been evaluated, and through
                a process
                of elimination, we have developed favored materials and methods during
                our
                laboratory testing. The equipment necessary to produce the internal
                core
                includes accurate cutting and gauging devices, isotope incorporation
                vessels, reaction condition stabilization and monitoring systems,
                and
                tools for placing the core into the titanium tubing prior to seed
                welding*.*


·
            *Seed
                Welding.*******Following
                production of the internal core and placement into the titanium capsule,
                each seed is laser welded to produce a sealed radioactive source
                and
                biocompatible medical device. This manufacturing technology requires:
                accurate placement of seed components with respect to the welding
                head,
                accurate control of welding parameters to ensure uniform temperature
                and
                depth control of the weld, quality control assessment of the weld
                integrity, and removal of the finished product for downstream processing
                or rejection of unacceptable materials to waste. Inspection systems
                are
                capable of identifying and classifying these variations for quality
                control and to ensure low scrap rates. Finally, the rapid placement
                and
                removal of components from the welding zone affects overall product
                throughput.


·
            *Quality
                Control*.****We
                have established procedures and controls to meet all FDA and ISO
                9001:2000
                Quality Standards. Product quality and reliability will be secured
                by
                utilizing multiple sources of irradiation services, feedstock material,
                and other seed manufacturing components. An intensive production
                line
                preventive maintenance and spare parts program will be implemented.
                Also,
                an ongoing training program will be established for customer service
                to
                ensure that all regulatory requirements for the FDA, DOT and applicable
                nuclear radiation and health authorities are
                fulfilled.




The
      Company has implemented a just-in-time production process that is keenly
      responsive to customer input and orders to ensure that individual customers
      receive a higher level of customer service from us than from existing seed
      suppliers who have the luxury of longer lead times due to longer half-life
      products. Time from order confirmation to completion of product manufacture
      can
      be reduced to several working days, including receipt of irradiated barium
      (from
      a supplier’s reactor), separation of Cs-131 (at our facilities), isotope
      labeling of the core, and loading of cores into pre-welded titanium “cans” for
      final welding, testing, quality assurance and shipping.




It
      is up
      to each physician to determine the dosage necessary for implants and acceptable
      dosages vary among physicians. Many of the physicians who order our seeds order
      more seeds than necessary but wish to assure themselves that they have a
      sufficient amount. Upon receipt of an order, the Company either delivers the
      seeds from its facility directly to the physician using Federal Express or
      sends
      the order to an independent preloading service which delivers the seeds
      preloaded into needles just prior to implant. If the implant is postponed or
      rescheduled, the short half-life of the seeds makes them unsuitable for use
      and
      therefore they must be re-ordered. The Company's historical profit margin on
      seeds has been sufficient to justify unusable inventory and management has
      monitored the amount of unused inventory carefully to review its calculations
      of
      wastage in its business plans.




*Automated
      Manufacturing Process*





IsoRay
      has held discussions with leading designers and manufacturers of automated
      seed
      manufacturing equipment that have manufactured, installed and deployed automated
      production lines in Europe and the United States. In addition, IsoRay engaged
      in
      preliminary discussions with another seed manufacturer regarding obtaining
      an
      existing automated seed production line. Based on technical evaluations and
      on
      site reviews of both options, IsoRay elected to automate its current
      manufacturing process in phases. Current production rates with IsoRay’s semi
      automated seed welding equipment exceed those attainable with fully automated
      lines. Phased implementation of automation is expected to be less costly than
      fully automated production lines and will benefit IsoRay by reducing labor
      costs
      and helping to ensure consistent manufacturing quality.




13




*Manufacturing
      Facility*




The
      initial production of the IsoRay Cs-131 brachytherapy seed commenced at PNNL
      in
      2004. IsoRay has signed a lease agreement and completed construction (tenant
      improvements) of a new interim production facility in Richland, Washington
      that
      received final regulatory approval on October 6, 2005 and began radioactive
      production operations shortly thereafter. The Company is also considering
      another state as a location for a future facility, either as the Company’s sole
      manufacturing facility or as a secondary production facility. No agreements
      have
      been reached for any possible facilities outside of Washington.





*Isotope
      Testing in Idaho*





On
      December 14, 2005, IsoRay and Idaho’s Advanced Test Reactor (“ATR”) entered into
      a collaboration and partnership agreement for the design, analysis and
      fabrication of a capsule containing barium carbonate, to be irradiated at the
      ATR and then shipped to IsoRay for processing and analysis of the 131 Cs
      product.  As an adjunct to this testing, IsoRay and the Pocatello
      Development Authority entered into an Economic Development Agreement, dated
      December 14, 2005, under which the Pocatello Development Authority provided
      IsoRay with $200,000 (subject to repayment under certain conditions) to use
      toward the cost of testing at the ATR.  During July 2006, several capsules
      were irradiated and shipped to IsoRay’s PIRL facility for analysis.  The
      results of the analyses indicate the capsule performed as designed and that
      a
      planned capsule shuttle system will provide adequate conditions for 131 Cs
      production that will enhance IsoRay’s overall production capacity.





*Repackaging
      Services*





Most
      brachytherapy manufacturers offer their seed product to the end user packaged
      in
      four principal configurations provided in a sterile or non-sterile package
      depending on the customer’s preference. These include:





·
            *Loose
                seeds*


·
            *Pre-loaded
                needles*(loaded with 3 to 5 seeds and
                spacers)


·
            *Strands
                of seeds*(consists of seeds and spacers in a biocompatible “shrink wrap”)


·
            *Pre-loaded
                Mick cartridges*(fits the Mick applicator - seed manufacturers usually load and sterilize
                Mick cartridges in their own manufacturing
                facilities)




No
      single
      package configuration dominates the market at this point. Market share
      estimates, based on internal management studies of the market, for each of
      the
      four packaging types are: loose seeds (negligible amount), Mick cartridges
      (20%), pre-loaded needles (30%) and strands (50%). Market trends indicate
      significant movement toward the stranded configuration, as there are some
      clinical data suggesting less potential for post-implant seed migration when
      a
      stranded configuration is used.




The
      role
      of the preloading service is to package, assay and certify the contents of
      the
      final product configuration shipped to the customer. A commonly used method
      of
      providing this service is through independent radiopharmacies such as Anazao
      Healthcare and Advanced Care Medical Inc. Manufacturers send loose seeds along
      with the physician's instructions to the radiopharmacy who, in turn, loads
      needles and/or strands the seeds according to the doctor's instructions. These
      pharmacies then sterilize the product and certify the final packaging prior
      to
      shipping directly to the end user.




IsoRay
      has held discussions with the major independent radiopharmacies and determined
      the additional time required for delivery of loose seeds to an off-site
      radiopharmacy for subsequent assay, preloading and sterilization creates
      additional loss of our isotope due to decay and is prohibitive on a long-term
      basis. However, to increase sales in the near-term we are using these services
      until our own custom preloading operation comes fully on-line in 2006. On March
      1, 2006, the Company entered into a Service Agreement with Advanced Care
      Medical, Inc. for preloading services. The term of the Service Agreement is
      one
      year, with automatic one year extensions unless terminated, and prices vary
      from
      $6 - 18 per seed
      depending on how the seeds are packaged. In late March 2006, the Company’s
      stranding service became operational but
      stranding activity was suspended pending FDA 510(k) clearance of preloaded
      seed
      configurations as devices rather than convenience kits for seeds. The 510(k)
      filing for the stranding activity was submitted to the FDA in August 2006 and
      the Company expects to receive clearance in the second quarter of fiscal
      2007.




14




The
      Company currently loads Mick cartridges in our own facility which in recent
      months accounted for more than 65% of total seed orders. The Company has
      retained a consultant to
      assist with implementation of the custom preloading service and  expects
      to begin offering its
      seed in all
      four of the commonly used packaging configurati ons to
      the
      rest of its customer base within forty-five to sixty days, pending FDA 510(k)
      clearance of selected preloaded seed configurations. Providing this service
      in-house will reduce the current cycle time for any given customer order by
      three to four days by eliminating the need to ship loose seeds to a third-party
      provider. This reduction in cycle time will eliminate approximately 25% loss
      in
      isotope activity due to radioactive decay. The cost of priority overnight
      shipment of each order of seeds to a third-party provider is also eliminated.
      However, we will
      continue to utilize the independent radiopharmacies in the future both as a
      backup to our own preloading operation and to handle periodic increases in
      demand.




Independent
      radiopharmacies usually provide the final packaging of the product delivered
      to
      the end user. This eliminates the opportunity for reinforcing the "branding"
      of
      our seed product. By providing its own repackaging service, the Company
      preserves the product branding opportunity and eliminates any concerns related
      to the handling of its product by a third party prior to delivery to the end
      user.




Providing
      different packaging configurations adds significant value to the product while
      providing an additional revenue stream and incremental margins to the Company
      through the pricing premiums that can be charged. The end users of these
      packaging options are willing to pay a premium because of the
      savings  they
      realize by eliminating the need for loose seed handling and loading capabilities
      on site, eliminating the need for additional staffing to load and sterilize
      seeds and needles, and eliminating the expense of additional assaying of the
      seeds.




Management
      estimates the cost of establishing the custom preloading service in its new,
      leased facility to be approximately $250,000, most of which has already been
      spent on capital equipment. The custom preloading area has been created in
      the
      facility and the necessary equipment has been delivered and installed. Operating
      procedures are in place, staff members have been trained, and process validation
      activities have been completed. Technicians have been added to the staff to
      handle the seed loading and stranding operations. As the Company is not
      currently performing the stranding function pending FDA 510(k) clearance, these
      staff members are currently being utilized in our seed production process.
      PNNL
      will continue to provide independent third-party assay of the seeds for the
      foreseeable future. Our customer service staff will provide assistance with
      shipping, documentation and tracking of all orders from the repackaging service
      to the end user.





*Barium
      Enrichment Device*





Barium-130
      is the original source material for Cs-131. When Ba-130 is put into a nuclear
      reactor it becomes Ba-131, the radioactive material that is the parent isotope
      of Cs-131. Barium metal found in nature contains only 0.1% of Ba-130 with six
      other isotopes making up the other 99.9%. As part of its manufacturing process
      the Company intends to develop a barium enrichment device that should create
      “enriched barium” with a higher concentration of the Ba-130 isotope than is
      found in naturally occurring barium. In addition to creating a higher purity
      Ba-130, which translates into higher purity Cs-131, a barium enrichment device
      will result in higher yields of Cs-131. The Company has identified sources
      of
      enriched barium, including in the former Soviet Union, that we are using until
      the barium enrichment device is developed.





15




**Marketing
      and Sales**





*Marketing
      Strategy*





The
      Company intends to position Cs-131 as the isotope of choice for prostate
      brachytherapy. Based on preliminary clinical studies, management believes there
      is no apparent clinical reason to use other isotopes when Cesium-131 is
      available. The advantages associated with a higher energy and shorter half-life
      isotope are generally accepted within the clinical community and the Company
      intends to help educate potential patients about the clinical benefits a patient
      would experience from the use of Cs-131 for their brachytherapy seed treatment.
      The potential negative effects of the prolonged radiation times associated
      with
      the long half-life of Iodine-125 make this isotope less attractive than
      Cesium-131.





We
      target
      competing isotopes as our principal competition rather than the various
      manufacturers and distributors of these isotopes. In this way, the choice of
      brachytherapy isotopes will be less dependent on the name and distribution
      strengths of the various iodine and palladium manufacturers and distributors
      and
      more dependent on the therapeutic benefits of Cs-131. The Company focuses the
      purchasing decision on the advantages and functionality of the Cs-131 isotope
      while seeking to educate the cancer patient about these clinical
      benefits.





The
      professional and patient market segments each play a role in the ultimate choice
      of cancer treatment and the specific isotope chosen for seed brachytherapy
      treatment. The Company is tailoring its marketing message to each audience.
      IsoRay has retained an advertising agency in the Seattle area to assist with
      its
      marketing communication program. The agency is coordinating the creation and
      distribution of all advertising material and work with the print and visual
      media.





We
      are
      seeking to promote the advantages of Cs-131’s unique combination of high energy
      and short half-life within the clinical market. Because we believe there is
      no
      apparent clinical reason to choose other isotopes over cesium, we have and
      will
      continue to target those high volume users of other isotopes as our implant
      sites. We also emphasize the prolonged radiation times and the high doses of
      radiation given to the patient by the iodine isotope and the possible negative
      effects of this prolonged radiation to the adjacent healthy tissues. We believe
      that this is an important marketing message because clinicians generally agree
      the radiation given by Iodine has little or no clinical benefit after 120 to
      150
      days.





To
      promote our products to the clinical and professional audience, we are using
      a
      combination of marketing messages to appear in print and visual media. Past
      and
      planned marketing activities include: attendance at the major
      brachytherapy-related clinical conferences to exhibit our products and provide
      marketing information for annual meetings, conferences and other forums of
      the
      various professional societies; print advertising in brachytherapy clinical
      journals; and promoting clinical presentations by experts in the field at major
      conferences.





In
      today’s U.S. health care market patients are more informed and involved in the
      management of their health and any treatments required. Many physicians relate
      incidents of their patients coming for consultations armed with articles
      researched on the Internet and other sources describing new treatments and
      medications. In many cases, these patients are demanding a certain therapy
      or
      drug and the physicians are complying when medically appropriate.





Because
      of this market factor, we also promote our products directly to the general
      population. The audience targeted will be the prostate cancer patient, his
      spouse, family and care givers. The marketing message to this segment of the
      market emphasizes the specific advantages of Cs-131, including fewer side
      effects, less total radiation, and shorter period of radiation. The Company
      is
      targeting this market through its website, located at www.isoray.com,
      advertising in magazines read by prostate cancer patients and their care givers,
      and through patient advocacy efforts.





16




Another
      key element of our strategy is to validate and support all product claims with
      well-designed and executed clinical studies that support the efficacy and
      positive patient outcomes of our Cs-131 seed. We intend to sponsor
      physician-directed studies that will compare the performance of our seeds to
      Pd-103 and I-125 seeds. During the remainder of 2006 and into 2007, IsoRay
      plans
      to continue its collaboration with leading physicians to develop clinical data
      on the efficacy of Cs-131 seeds. Noted contributors from the medical physics
      community will be consulted regarding the benefits of brachytherapy using
      shorter half-life, improved dosimetry, and higher decay energy seeds. Articles
      will be submitted to professional journals such as *Medical
      Physics* and the *International
      Journal of Radiation*  *Oncology,
      Biology, and Physics* .





*Sales
      and Distribution*





According
      to a recent industry survey, approximately 2,000 hospitals and free standing
      clinics are currently offering radiation oncology services in the United States.
      Not all of these facilities offer seed brachytherapy services. These
      institutions are staffed with radiation oncologists and medical physicists
      who
      provide expertise in radiation therapy treatments and serve as consultants
      for
      urologists and prostate cancer patients. We target the radiation oncologists
      and
      the medical physicists as well as urologists as key clinical decision makers
      in
      the type of radiation therapy offered to prostate cancer patients.





IsoRay
      has a direct sales organization to introduce Cs-131 to radiation oncologists
      and
      medical physicists. During 2006, IsoRay expanded its sales force to four
      experienced individuals. By hiring experienced and successful brachytherapy
      sales people, the Company reduces the risk of delay in penetrating the market
      due to a lack of knowledge of the industry or unfamiliarity with the key members
      of the brachytherapy community.





The
      initial response to our new isotope from prominent radiation oncologists,
      medical physicists and urologists in the US has been very positive. As of
      September 1, 2006, the Company had supplied the 131 Cs
      seed
      to 27 well-known implant centers strategically located throughout the
      U.S.





The
      Company will expand its U.S. sales force as it expands the customer base. If
      the
      Company implements its plans to expand outside the U.S. market, it plans to
      use
      established distributors in the key markets in these other countries. This
      strategy should reduce the time and expense required to identify, train and
      penetrate the key implant centers and establish relationships with the key
      opinion leaders in these markets. Using established distributors also should
      reduce the time spent acquiring the proper radiation handling licenses and
      other
      regulatory requirements of these markets.





*Pricing*





Payment
      for IsoRay products comes from third-party payers including Medicare/Medicaid
      and private insurance groups. These payers reimburse the hospitals and clinics
      via well-established payment procedures. On October 31, 2003, as a result of
      IsoRay’s predecessor’s filing for an Additional Device Category, CMS (Centers
      for Medicare and Medicaid Services) approved a HCPCS/CPT code for Cs-131
      brachytherapy seeds of $44.67 per seed. This is the same price as awarded to
      Pd-103 seeds, and compares favorably to the $37.34 price granted to I-125 seeds.
      Medicare is the most significant U.S. payer for prostate brachytherapy services,
      and is the payer in approximately 70% of all U.S. prostate brachytherapy cases.
      CMS reviews and adjusts outpatient reimbursement on a periodic and ad hoc basis,
      but no changes are expected for 2006. As of July 31, 2005, the price for our
      loose seeds was $55 per seed but we plan to increase this price to $59.00 as
      of
      October 1, 2006.





Prostate
      brachytherapy is typically performed in an outpatient setting, and as such,
      is
      covered by the CMS Outpatient Prospective Payment System. In January 2004,
      brachytherapy procedure prices were unbundled by CMS, allowing itemized
      invoicing for seeds with no limit on the number of seeds used per procedure,
      and
      CMS currently reimburses hospitals and clinics for their seed purchases on
      a
      cost basis. Other insurance companies have followed these CMS changes. With
      the
      new reimbursement structure and industry consolidation, management believes
      that
      prices of brachytherapy seeds will stabilize and increase over the next few
      years.




17




When
      charges for the seeds are correctly submitted in the appropriate format to
      CMS,
      100% of the total cost of the seeds is reimbursed to the hospital or clinic
      by
      CMS.




**Other
      Information**




*Customers*





Customers
      representing ten percent or more of total Company sales for the twelve months
      ended June 30, 2006 include:




Community
                Hospital of Los Gatos
            
            Los
                Gatos, CA
            
            20.1%
                of revenueChicago
                Prostate Cancer Center
            
            Westmont,
                IL
            
            18.7%
                of revenueMills
                Peninsula Health Center
            
            San
                Mateo, CA
            
            10.4%
                of revenue





The
      loss
      of any of these significant customers would have a temporary adverse effect
      on
      the Company’s revenues, which would continue until the Company located new
      customers to replace them.




*Proprietary
      Rights*




The
      Company relies on a combination of patent, copyright and trademark laws, trade
      secrets, software security measures, license agreements and nondisclosure
      agreements to protect its proprietary rights. Some of the Company’s proprietary
      information may not be patentable.




The
      Company intends to vigorously defend its proprietary technologies, trademarks,
      and trade secrets. Members of management, employees, and certain equity holders
      have previously signed non-disclosure, non-compete agreements, and future
      employees, consultants, advisors, with whom the Company engages, and who are
      privy to this information, will be required to do the same. A patent for the
      Cesium separation and purification process was granted on May 23, 2000 by the
      U.S. Patent and Trademark Office (USPTO) under Patent Number 6,066,302, with
      an
      expiration date of May 23, 2020. The process was developed by Lane Bray, a
      shareholder of the Company, and has been assigned exclusively to IsoRay.
      IsoRay’s predecessor also filed for patent protection in four European countries
      under the Patent Cooperation Treaty. Those patents have been assigned to
      IsoRay.





Our
      management believes that certain aspects of the IsoRay seed design and
      construction techniques are patentable innovations. These innovations have
      been
      documented in IsoRay laboratory records, and a patent application was filed
      with
      the USPTO on November 12, 2003. Certain methodologies regarding isotope
      production, separation, and seed manufacture are retained as trade secrets
      and
      are embodied in IsoRay’s procedures and documentation. In June and July of 2004,
      three patent applications were filed relating to methods of deriving Cs-131
      developed by IsoRay employees. The Company is currently working on developing
      and patenting additional methods of deriving Cs-131 and other isotopes.





There
      are
      specific conditions attached to the assignment of the Cs-131 patent from Lane
      Bray. In particular, the associated Royalty Agreement provides for 1% of gross
      profit payment from seed sales (gross seed sales price minus direct production
      cost) to Lane Bray and 1% of gross profit from any use of the Cs-131 process
      patent for non-seed products. If IsoRay reassigns the Royalty Agreement to
      another company, these royalties increase to 2%. The Royalty Agreement has
      an
      anti-shelving clause which requires IsoRay to return the patent if IsoRay
      permanently abandons sales of products using the invention.





Effective
      August 1, 1998, Pacific Management Associates Corporation (PMAC) transferred
      its
      entire right, title and interest in an exclusive license agreement with Donald
      Lawrence to IsoRay, LLC (a predecessor company) in exchange for a membership
      interest. The license agreement was transferred to IsoRay through a series
      of
      mergers and the reverse acquisition.




18




The
      terms
      of the license agreement require the payment of a royalty based on the Net
      Factory Sales Price, as defined in the agreement, of licensed product sales.
      Because the licensor’s patent application was ultimately abandoned, only a 1%
“know-how” royalty based on Net Factory Sales Price, as defined, remains
      applicable. To date, there have been no product sales incorporating the licensed
      technology and there is no royalty due pursuant to the terms of the agreement.
      Management believes that because this technology is not presently being used
      and
      believes it will not be used in the future that no royalties will be paid under
      this agreement.




*Research
      And Development*




From
      inception (December 17, 2001) through June 30, 2006, IsoRay and its predecessor
      companies incurred more than $2.25 million in costs related to research and
      development activities. The Company expects to continue to have employees
      working on activities that will be classified as research or development for
      the
      foreseeable future.




*Government
      Regulation*




The
      Company's present and future intended activities in the development, manufacture
      and sale of cancer therapy products are subject to extensive laws, regulations,
      regulatory approvals and guidelines. Within the United States, the Company's
      therapeutic radiological devices must comply with the U.S. Federal Food, Drug
      and Cosmetic Act, which is enforced by the FDA. The Company is also required
      to
      adhere to applicable FDA regulations for Good Manufacturing Practices, including
      extensive record keeping and periodic inspections of manufacturing facilities.
      IsoRay's predecessor obtained FDA 510(k) clearance in March 2003 to market
      the
      IsoRay 131 Cs
      seed
      for the treatment of localized solid tumors.





Specifically,
      in the United States, the FDA regulates, among other things, new product
      clearances and approvals to establish the safety and efficacy of these products.
      We are also subject to other federal and state laws and regulations, including
      the Occupational Safety and Health Act and the Environmental Protection Act.





The
      Federal Food, Drug, and Cosmetic Act and other federal statutes and regulations
      govern or influence the research, testing, manufacture, safety, labeling,
      storage, record keeping, approval, distribution, use, reporting, advertising
      and
      promotion of such products. Noncompliance with applicable requirements can
      result in civil penalties, recall, injunction or seizure of products, refusal
      of
      the government to approve or clear product approval applications,
      disqualification from sponsoring, or conducting clinical investigations, prevent
      us from entering into government supply contracts, withdrawal of previously
      approved applications and criminal prosecution.




Approval
      of new medical devices is a lengthy procedure and can take a number of years
      and
      the expenditure of significant resources. There is a shorter FDA review and
      clearance process, the premarket notification process, or the 510(k) process,
      whereby a company can market certain medical devices that can be shown to be
      substantially equivalent to other legally marketed devices. We have been able
      to
      achieve market clearance for our 131 Cs
      seed
      using the 510(k) process.




In
      the
      United States, medical devices are classified into three different categories
      over which FDA applies increasing levels of regulation: Class I,
      Class II and Class III. Most Class I devices are exempt from
      premarket notification (510(k)); most Class II devices require premarket
      notification (510(k)) and most Class III devices require premarket
      approval. Our 131 Cs
      seed
      is a Class II device and has received 510(k) clearance.




As
      a
      registered medical device manufacturer with the FDA, we are subject to
      inspection to ensure compliance with their current Good Manufacturing Practices,
      or cGMP. These regulations require that we and any of our contract manufacturers
      design, manufacture and service products and maintain documents in a prescribed
      manner with respect to manufacturing, testing, distribution, storage, design
      control and service activities. Modifications or enhancements that could
      significantly affect the safety or effectiveness of a device or that constitute
      a major change to the intended use of the device require a new 510(k) notice
      for
      any product modification. We may be prohibited from marketing the modified
      product until the 510(k) notice is cleared by the FDA.





19




The
      Medical Device Reporting regulation requires that we provide information to
      the
      FDA on deaths or serious injuries alleged to be associated with the use of
      our
      devices, as well as product malfunctions that are likely to cause or contribute
      to death or serious injury if the malfunction were to recur. Labeling and
      promotional activities are regulated by the FDA and, in some circumstances,
      by
      the Federal Trade Commission.




As
      a
      medical device manufacturer, we are also subject to laws and regulations
      administered by governmental entities at the federal, state and local levels.
      For example, our facility is licensed as a medical product manufacturing
      facility in the State of Washington and is subject to periodic state regulatory
      inspections. Our customers are also subject to a wide variety of laws and
      regulations that could affect the nature and scope of their relationships with
      us.




In
      the
      United States, as a manufacturer of medical devices and devices utilizing
      radioactive byproduct material, we are subject to extensive regulation by not
      only federal governmental authorities, such as the FDA, but also by state and
      local governmental authorities, such as the Washington State Department of
      Health, **** to
      ensure
      such devices are safe and effective. In Washington State, the Department of
      Health, by agreement with the federal Nuclear Regulatory Commission ("NRC"),
      regulates the possession, use, and disposal of radioactive byproduct material
      as
      well as the manufacture of radioactive sealed sources to ensure compliance
      with
      state and federal laws and regulations. Our 131 Cs
      brachytherapy seeds constitute both medical devices and radioactive sealed
      sources and are subject to these regulations.




Moreover,
      our use, management and disposal of certain radioactive substances and wastes
      are subject to regulation by several federal and state agencies depending on
      the
      nature of the substance or waste material. We believe that we are in compliance
      with all federal and state regulations for this purpose.




Washington
      voters approved Initiative 297 in late 2004, which may impose additional
      restrictions on sites at which mixed radioactive and hazardous wastes are
      generated and stored, including PNNL, as it prohibits additional mixed
      radioactive and hazardous waste from being brought to sites, such as PNNL,
      until
      the existing on-site waste conforms to all state and federal environment laws.
      In June 2006, a U.S. District court judge ruled that Initiative 297 was
      unconstitutional in its entirety. However, the state of Washington has indicated
      that it would appeal the decision. If this decision is overturned and Initiative
      297 is enforced it could impact our ability to manufacture our seeds, whether
      at
      PNNL or elsewhere in the State of Washington.




*Seasonality*




The
      Company is now aware of a seasonal influence on its business. During the months
      of July and August, physicians take vacations and defer seed implantation
      surgeries causing a momentary decline in revenue which management believes
      is
      ultimately realized later.




*Employees*




As
      of
      September 1, 2006, IsoRay employed 53 full-time individuals and one part-time
      individual. The Company's future success will depend, in part, on its ability
      to
      attract, retain, and motivate highly qualified technical and management
      personnel. From time to time, the Company may employ independent consultants
      or
      contractors to support its research and development, marketing, sales and
      support and administrative organizations. None of the Company's employees are
      represented by any collective bargaining unit. IsoRay estimates that successful
      implementation of its growth plan would result in up to 30 additional employees
      by the end of calendar year 2007.





20




*Competition*





The
      Company competes in a market characterized by technological innovation,
      extensive research efforts and significant competition. In general, the IsoRay
      seed competes with conventional methods of treating localized cancer, including,
      but not limited to, radical prostatectomy and external beam radiation therapy
      which includes intensity modulated radiation therapy, as well as competing
      permanent brachytherapy devices. RP has historically represented the most common
      medical treatment for early-stage, localized prostate cancer. EBRT is also
      a
      well-established method of treatment and is widely accepted for patients who
      represent a poor surgical risk or whose prostate cancer has advanced beyond
      the
      stage for which surgical treatment is indicated. Management believes that if
      general conversion from these treatment options (or other established or
      conventional procedures) to the IsoRay seed does occur, such conversion will
      likely be the result of a combination of equivalent or better efficacy, reduced
      incidence of side effects and complications, lower cost, quality of life issues
      and pressure by health care providers and patients.





History
      has shown the advantage of being the first to market a new brachytherapy
      product. For example, Oncura currently claims nearly 30% of the market with
      the
      original I-125 seed. Theragenics Corp., which introduced the original Pd-103
      seed, is second with a nearly 30% market share. The Company believes it may
      obtain a similar and significant advantage by being the first to introduce
      a
      Cs-131 seed.





The
      Company’s patented Cs-131 separation process is likely to provide us a
      sustainable competitive advantage in this area. Production of Cs-131 also
      requires specialized facilities (hot cells) that represent high cost and long
      lead time if not readily available. In addition, a competitor would need to
      develop a method for isotope attachment and seed assembly, would need to conduct
      testing to meet NRC and FDA requirements, and would need to obtain regulatory
      approvals before marketing a competing device.





Several
      companies have obtained regulatory approval to produce and distribute
      Palladium-103 and Iodine-125 seeds, which compete directly with our seed. Six
      of
      those companies represent nearly 100% of annual brachytherapy seed sales
      worldwide: CR Bard, Inc., Oncura (part of Galil), Theragenics Corp., North
      American Scientific, Inc., Mentor Corp., and Best Medical International, Inc.
      The top three - CR Bard, Inc., Oncura and Theragenics - currently garner over
      80% of annual sales.




It
      is
      possible that three or four of the current I-125 or Pd-103 seed manufacturers
      (e.g., Oncura, Theragenics, North American Scientific, etc.) are capable of
      producing and marketing a Cs-131 seed, but none have reported efforts to do
      so.
      Best Medical obtained a seed core patent in 1992 that named 10 different
      isotopes, including Cs-131, for use in their seeds. Best Medical received FDA
      510(k) approval to market a Cs-131 seed on June 6, 1993 but has failed to
      produce any products for sale.





*Additional
      Growth Opportunities*





The
      Cs-131 isotope has the performance characteristics to be a technological
      platform for sustained long-term growth. The most immediate opportunities are
      introducing Cs-131 to Canada, Europe and other international markets,
      introducing Cs-131-based therapies for other forms of solid tumors focusing
      first on breast tumors, and through the marketing of other radioactive isotopes.
      These growth initiatives are in the early stages of planning and appear to
      be
      significant incremental opportunities.





The
      Company plans to introduce Cs-131  initially
      into Europe and later into other international markets through partnerships
      and
      strategic alliances with channel partners for manufacturing and distribution.
      Another advantage of the Cs-131 isotope is its potential applicability to other
      cancers and other diseases. Cs-131 has FDA approval to be used for treatments
      for a broad spectrum of cancers including breast, brain, lung, and liver cancer,
      and the Company believes that a major opportunity exists as an adjunct therapy
      for the treatment of breast cancer. Preliminary discussions have begun with
      prominent physicians regarding the use of Cs-131-based therapies for the
      treatment of lung, pancreatic and brain cancer. There is the opportunity to
      develop and market other radioactive isotopes to the US market, and to market
      the Cs-131 isotope itself, separate from its use in our seeds. The Company
      is
      also in the preliminary stages of exploring alternate methods of delivering
      our
      isotopes to various organs of the body, as it may be advantageous to use
      delivery methods other than a titanium-encapsulated seed to deliver radiation
      to
      certain organs.





21




**Risk
      Factors**





*Our
      Independent Accountants Have Expressed Doubt About Our Ability To Continue
      As A
      Going Concern* .
      IsoRay
      has generated material operating losses since inception. We expect to continue
      to experience net operating losses. Our ability to continue as a going concern
      is subject to our ability to obtain necessary funding from outside sources,
      including obtaining additional funding from the sale of our securities or
      obtaining loans and grants from various financial institutions where possible.
      The substantial doubt expressed by IsoRay’s auditors about its ability to
      continue as a going concern increases the difficulty in meeting such goals.
      IsoRay began generating revenue in October 2004 and is in the early stages
      of
      marketing its IsoRay 131 Cs
      seed.
      IsoRay has limited historical, operating or financial information upon which
      to
      evaluate its performance. There can be no assurance that the Company will attain
      profitability.





*Our
      Revenues Depend Upon One Product.* Until
      such time as we develop additional products, our revenues depend upon the
      successful production, marketing, and sales of the IsoRay 131 Cs
      seed.
      The rate and level of market acceptance of this product may vary depending
      on
      the perception by physicians and other members of the healthcare community
      of
      its safety and efficacy as compared to that of competing products, if any;
      the
      clinical outcomes of the patients treated; the effectiveness of our sales and
      marketing efforts in the United States and Europe; any unfavorable publicity
      concerning our product or similar products; our product’s price relative to
      other products or competing treatments; any decrease in current reimbursement
      rates from the Centers for Medicare and Medicaid Services or third-party payers;
      regulatory developments related to the manufacture or continued use of the
      product; availability of sufficient supplies of enriched barium for 131 Cs
      seed
      production; ability to produce sufficient quantities of this product; and the
      ability of physicians to properly utilize the device and avoid excessive levels
      of radiation to patients. Because of our reliance on this product as the sole
      source of our revenue, any material adverse developments with respect to the
      commercialization of this product may cause us to continue to incur losses
      rather than profits in the future.




*Although
      Approved To Treat Any Malignant Tissue, Our Sole Product Is Currently Used
      To
      Treat One Type Of Cancer.* Currently,
      the IsoRay 131 Cs
      seed
      is used exclusively for the treatment of prostate cancer. We believe the 131 Cs
      seed
      will be used to treat cancers of other sites as well, as is currently the case
      with our competitors’ 125 I
      and 103 Pd
      seeds.
      However, we believe that clinical data gathered by select groups of physicians
      under treatment protocols specific to other organs will be needed prior to
      widespread acceptance of our product for treating other cancer sites. If our
      current and future products do not become accepted in treating cancers of other
      sites, our sales will depend solely on treatment of prostate cancer and will
      require ever increasing market share to increase revenues.




*We
      Have Limited Data On The Clinical Performance Of* *131* *Cs* .
      As of
      September 1, 2006, the IsoRay 131 Cs
      seed
      has been implanted in over 500 **** patients.
      While this number of patients may prevent us from drawing statistically
      significant conclusions, the side effects experienced by these patients were
      less severe than side effects observed in seed brachytherapy with 125 I
      and 103 Pd
      and in
      other forms of treatment such as radical prostatectomy These early results
      indicate that the onset of side effects generally occurs between one and three
      weeks post-implant, and the side effects are resolved between five and eight
      weeks post-implant, indicating that, at least for these initial patients, side
      effects resolved more quickly than the side effects that occur with competing
      seeds or with other forms of treatment. These limited findings support
      management’s belief that the 131 Cs
      seed
      will result in less severe side effects than competing treatments, but we may
      have to gather data on outcomes from additional patients before we can establish
      statistically valid conclusions regarding the incidence of side effects from
      our
      seeds.




22




*We
      Will Need To Raise Additional Capital* .
      The
      hiring of upper level executives and increasing production requirements
      significantly increased IsoRay’s monthly cash requirements since August 2005.
      Monthly operating cash requirements as of September 1, 2006 were approximately
      $800,000, excluding capitalized items. Capital expenditures typically include
      the purchase or capital lease of equipment, with a life-expectancy of more
      than
      12 months, costing in excess of $2,500, which would include among other things:
      analytical systems, improved packaging for final products and, new production
      systems which increase manufacturing throughput. Ongoing requirements to meet
      greater payroll obligations coupled with legal and accounting fees associated
      with our public reporting status have resulted in greater amounts of short-term
      cash demands. IsoRay will need to continue to raise capital.





We
      will
      also need substantial funds to complete the development, manufacturing, and
      marketing of our current and future products. Consequently, we will seek to
      raise additional capital through not only public and private offerings of equity
      and debt securities, but also collaborative arrangements, strategic alliances,
      or from other sources. We will need to raise at least $3.2 million of additional
      capital to fund working capital needs through the end of fiscal year 2007.
      IsoRay currently has a manufacturing and production facility located in
      Richland, Washington that its management believes will provide adequate space
      to
      manufacture the 131 Cs
      seed
      product for the prostate and other organ cancer markets until late 2007.





We
      may be
      unable to raise additional capital on commercially acceptable terms, if at
      all,
      and if we raise capital through additional equity financing, existing
      shareholders may have their ownership interests diluted. Our failure to be
      able
      to generate adequate funds from operations or from additional sources would
      harm
      our business.





*The
      Passage Of Initiative 297 In Washington May Result In The Relocation Of Our
      Manufacturing Operations.* Washington
      voters approved Initiative 297 in late 2004, which may impose restrictions
      on
      sites at which mixed radioactive and hazardous wastes are generated and stored.
      IsoRay has been assured by the Attorney General’s office of the State of
      Washington that medical isotopes are not included in Initiative 297 and that
      manufacturing in IsoRay’s new production facility would not be interrupted, but
      there is no assurance that this interpretation of Initiative 297 by the Attorney
      General’s Office will continue to exclude medical isotopes. In June 2006, a U.S.
      District court judge ruled that Initiative 297 was unconstitutional in its
      entirety. However, the state of Washington has indicated that it may appeal
      the
      decision. If this decision is overturned and Initiative 297 is enforced it
      could
      impact our ability to manufacture our seeds in the State of
      Washington.





Management
      believes that we will be able to continue our manufacturing operations in the
      State of Washington for the foreseeable future. In the event Initiative 297
      is
      enforced against us, management may consider establishing an alternate
      manufacturing facility outside of Washington, and we may consider moving all
      or
      part of our operations to another state even if Initiative 297 is not enforced
      against us.





*We
      Have Limited Manufacturing Experience And May Not Be Able To Meet
      Demand* .
      The
      existing management team and staff of IsoRay have experience primarily in
      research and development of products and our experience in commercial-scale
      manufacturing is limited. IsoRay began commercial production of the 131 Cs
      seed
      in the fourth quarter of 2004. Although IsoRay’s management team has significant
      radiochemistry experience, there is a possibility that production demands may
      result in challenges that may be too difficult or expensive to overcome. IsoRay
      has developed and deployed semi-automated laser welding equipment that can
      produce seeds faster than fully-automated equipment the Company has reviewed
      that would cost several million dollars to design and fabricate. IsoRay believes
      it will continually find more efficient means of welding the titanium seeds;
      however, there is a possibility that future demand will outstrip our ability
      to
      produce seeds using the semi-automated process. With its new facility, IsoRay’s
      management believes that IsoRay will be able to meet future demand unless demand
      greatly exceeds management’s current projections, which management does not
      believe will occur. IsoRay has entered into a lease agreement and has relocated
      to a manufacturing and production facility located in Richland, Washington
      that
      management believes will provide adequate space to manufacture 131 Cs
      seed
      product for the prostate and other organ cancer markets until late 2007.




23




*Sales
      And Marketing Experience.* IsoRay’s
      sales and marketing team has extensive experience in successfully establishing
      and training domestic and international sales forces as well as successfully
      introducing new medical devices to the market, but we have limited specific
      experience with commercial sales and marketing of the Cesium-131 radioisotope.
      IsoRay has employed marketing professionals with extensive experience selling
      medical devices, including radioisotopes for large, international companies.
      Our
      initial marketing activities have been targeted to a limited number of
      physicians and treatment centers, and we will need to recruit additional
      employees to assist in expanding our customer base. We have developed in-house
      customer service, order entry, shipping, billing, and sales support. In
      addition, the Company engaged a nationally recognized reimbursement specialist,
      Kathy Francisco, of the Pinnacle Health Group, with over 25 years of healthcare
      reimbursement experience, to assist with reimbursement questions and to provide
      reimbursement guidelines and appropriate insurance coding numbers needed to
      obtain reimbursement for seed costs and the implant procedure by our customers.
      Although, this group and other consultants continue to be available to support
      the Company in its reimbursement and marketing programs, we cannot be certain
      that our products will be marketed and distributed in accordance with our
      expectations or that our market research will be accurate. We also cannot be
      certain that we will be able to develop our own sales and marketing capabilities
      to the extent anticipated by management. We may choose to add third-party
      distribution channels, but we may not be able to maintain satisfactory
      arrangements with the third parties upon whom we rely.




*We
      Are Subject To The Risk That Certain Third Parties May Mishandle Our Product.* We
      rely
      on third parties, such as Federal Express, to deliver our 131 Cs
      seed,
      and on other third parties, including various radiopharmacies, to package our 131 Cs
      seed
      in certain specialized packaging forms that, as of the date of this report,
      we
      do not provide at our own facilities. We are subject to the risk that these
      third parties may mishandle our product, which could result in adverse effects,
      particularly given the radioactive nature of our product. As an example, on
      January 5, 2006, IsoRay was notified by one of its primary customers, Chicago
      Prostate Cancer Center (“CPCC”), that it would no longer accept 131 Cs
      products from the radiopharmacy exclusively used by IsoRay at that time due
      to
      quality control concerns. The role of the radiopharmacy is to provide
      third-party assay, preloading, and sterilization of the 131 Cs
      seeds
      which are then shipped directly to customers for use in patient implants. IsoRay
      immediately began working to bring these functions in house. On March 28, 2006,
      following commencement of operations of the Company’s pre-load department, which
      performs third-party assay, preloading and sterilization of the 131 Cs
      seeds,
      CPCC resumed ordering from us. Initial shipments of 131 Cs
      seeds,
      custom-loaded to this customer’s specifications, met the quality control
      guidelines established by CPCC. Although the temporary three month suspension
      of
      seed orders by CPCC had a negative impact on revenue in the quarter ended March
      31, 2006, the Company’s management believes any long-term impact will be
      nominal.




*Our
      Operating Results Will Be Subject To Significant Fluctuations.* Our
      quarterly revenues, expenses, and operating results are likely to fluctuate
      significantly in the future. Fluctuation may result from a variety of factors,
      which are discussed in detail throughout this “RISK FACTORS” section,
      including:





·
            our
                achievement of product development objectives and
                milestones;


·
            demand
                and pricing for the Company’s
                products;


·
            effects
                of aggressive competitors;


·
            hospital,
                clinic and physician buying
                decisions;


·
            research
                and development and manufacturing
                expenses;


·
            patient
                outcomes from our therapy;


·
            physician
                acceptance of our products;


·
            government
                or private healthcare reimbursement
                policies;


·
            our
                manufacturing performance and
                capacity;


·
            incidents,
                if any, that could cause temporary shutdown of our manufacturing
                facilities;


·
            the
                amount and timing of sales orders;


·
            rate
                and success of future product
                approvals;




24




·
            timing
                of FDA approval, if any, of competitive products and the rate of
                market
                penetration of competing products;


·
            seasonality
                of purchasing behavior in our
                market;


·
            overall
                economic conditions; and


·
            the
                successful introduction or market penetration of alternative
                therapies.





*We
      Rely Heavily On A Limited Number Of Suppliers.* Some
      materials used in our products are currently available only from a limited
      number of suppliers. For example, virtually all titanium tubing used in
      brachytherapy seed manufacture comes from a single source, Accellent
      Corporation. We currently obtain a key component of our seed core from a single
      supplier. We do not have formal written agreements with either this key supplier
      or with Accellent Corporation. Any interruption or delay in the supply of
      materials required to produce our products could harm our business if we were
      unable to obtain an alternative supplier or substitute equivalent materials
      in a
      cost-effective and timely manner. Additional factors that could cause
      interruptions or delays in our source of materials include limitations on the
      availability of raw materials or manufacturing performance experienced by our
      suppliers and a breakdown in our commercial relations with one or more
      suppliers. Some of these factors may be completely out of our control and our
      suppliers’ control.





*Future
      Production Increases Will Depend on Our Ability to Acquire Larger Quantities
      of* *131* *Cs
      and Hire More Employees.* IsoRay
      currently obtains 131 Cs
      through reactor irradiation of natural barium and subsequent separation of
      cesium from the irradiated barium targets. The amount of 131 Cs
      that
      can be produced from a given reactor source is limited by the power level and
      volume available within the reactor for irradiating targets. This limitation
      can
      be overcome by utilizing barium feedstock that is enriched in the stable isotope 130 Ba.
      However, the number of suppliers of enriched barium is limited and they may
      be
      unable to produce this material in sufficient quantities at a reasonable
      price.





IsoRay
      has entered into an exclusive agreement with the Institute of Nuclear Materials
      in the former Soviet Union to provide irradiated barium and 131 Cs
      in
      quantities sufficient to supply a significant percentage of future demand for 131 Cs.
      Delivery of the isotopes from the Institute of Nuclear Materials began in
      January 2006. IsoRay believes this supplier may also provide access to
      sufficient quantities of enriched barium that may be recycled for use in other
      reactors to increase the production of 131 Cs.
      Although the agreement provides for supplying 131 Cs
      in
      significant quantities, there is no assurance that this will result in IsoRay
      gaining access to a sufficient supply of enriched barium feedstock and if
      sufficient supplies are attained we will need to increase our manufacturing
      staff.





*We
      Are Subject To Uncertainties Regarding Reimbursement For Use Of Our Products.* Hospitals
      and freestanding clinics may be less likely to purchase our products if they
      cannot be assured of receiving favorable reimbursement for treatments using
      our
      products from third-party payers, such as Medicare, Medicaid and private health
      insurance plans. Currently, Medicare reimburses hospitals, clinics and
      physicians for the cost of seeds used in brachytherapy procedures on a per
      seed
      basis. Historically, private insurers have followed Medicare guidelines in
      establishing reimbursement rates. However, third-party payers are increasingly
      challenging the pricing of certain medical services or devices, and we cannot
      be
      sure that they will reimburse our customers at levels sufficient for us to
      maintain favorable sales and price levels for our products. There is no uniform
      policy on reimbursement among third-party payers, and we can provide no
      assurance that our products will continue to qualify for reimbursement from
      all
      third-party payers or that reimbursement rates will not be reduced. A reduction
      in or elimination of third-party reimbursement for treatments using our products
      would likely have a material adverse effect on our revenues.





In
      2003,
      IsoRay applied to the Centers for Medicare and Medicaid Services (CMS) and
      received reimbursement codes for use of our 131 Cs
      seed
      (HCPCS code C2633 and APC code 2633). However, since January 1, 2004 hospitals
      and clinics ordering brachytherapy seeds have been reimbursed for the cost
      of
      the seeds plus a fixed mark-up at a rate prescribed by CMS. Reimbursement
      amounts are reviewed and revised periodically, and on an ad hoc basis. Although
      the Company is not currently aware of any changes to CMS reimbursement rates
      that would have a material effect on our ability to maintain our pricing
      structure, adjustments could be made to these reimbursement amounts or policies,
      which could result in reduced reimbursement for brachytherapy services, which
      could negatively affect market demand for our products.





25




Furthermore,
      any federal and state efforts to reform government and private healthcare
      insurance programs could significantly affect the purchase of healthcare
      services and products in general and demand for our products in particular.
      We
      are unable to predict whether potential healthcare reforms will be enacted,
      whether other healthcare legislation or regulations affecting the business
      may
      be proposed or enacted in the future or what effect any such legislation or
      regulations would have on our business, financial condition or results of
      operations.





*It
      Is
      Possible That Other Treatments May Be Deemed Superior To Brachytherapy.* Our 131 Cs
      seed
      faces competition not only from companies that sell other radiation therapy
      products, but also from companies that are developing alternative therapies
      for
      the treatment of cancers. It is possible that advances in the pharmaceutical,
      biomedical, or gene therapy fields could render some or all radiation therapies,
      whether conventional or brachytherapy, obsolete. If alternative therapies are
      proven or even perceived to offer treatment options that are superior to
      brachytherapy, physician adoption of our product could be negatively affected
      and our revenues from our product could decline.





*Our
      Industry Is Intensely Competitive.* The
      medical products industry is intensely competitive. We compete with both public
      and private medical device, biotechnology and pharmaceutical companies that
      have
      been established longer than we have, have a greater number of products on
      the
      market, have greater financial and other resources, and have other technological
      or competitive advantages. We also compete with academic institutions,
      government agencies, and private research organizations in the development
      of
      technologies and processes and in acquiring key personnel. Although we have
      patents granted and patents applied for to protect our isotope separation
      processes and 131 Cs
      seed
      manufacturing technology, we cannot be certain that one or more of our
      competitors will not attempt to obtain patent protection that blocks or
      adversely affects our product development efforts. To minimize this potential,
      we have entered into exclusive agreements with key suppliers of isotopes and
      isotope precursors.





*We
      May Be Unable To Adequately Protect Or Enforce Our Intellectual Property Rights
      Or Secure Rights To Third-Party Patents.* Our
      ability and the abilities of our partners to obtain and maintain patent and
      other protection for our products will affect our success. We are assigned,
      have
      rights to, or have exclusive licenses to patents and patents pending in the
      U.S.
      and numerous foreign countries. The patent positions of medical device companies
      can be highly uncertain and involve complex legal and factual questions. Our
      patent rights may not be upheld in a court of law if challenged. Our patent
      rights may not provide competitive advantages for our products and may be
      challenged, infringed upon or circumvented by our competitors. We cannot patent
      our products in all countries or afford to litigate every potential violation
      worldwide.




Because
      of the large number of patent filings in the medical device and biotechnology
      field, our competitors may have filed applications or been issued patents and
      may obtain additional patents and proprietary rights relating to products or
      processes competitive with or similar to ours. We cannot be certain that U.S.
      or
      foreign patents do not exist or will not be issued that would harm our ability
      to commercialize our products and product candidates.




*One
      Of Our Licensed Patents May Be Terminated Under Certain
      Conditions* .
      Our 131 Cs
      separation patent is essential for the production of Cesium-131. The owner
      of
      the patent, Lane Bray, a shareholder of the Company and Chief Chemist of IsoRay,
      has the right to terminate the license agreement that allows the Company to
      use
      this patent if we discontinue production for any consecutive 18 month period.
      The Company has no plans to discontinue production, and management considers
      it
      highly unlikely that production will be discontinued for any significant period
      at any time in the future.





*Failure
      To Comply With Government Regulations Could Harm Our Business* .
      As a
      medical device and medical isotope manufacturer, we are subject to extensive,
      complex, costly, and evolving governmental rules, regulations and restrictions
      administered by the FDA, by other federal and state agencies, and by
      governmental authorities in other countries. Compliance with these laws and
      regulations is expensive and time-consuming, and changes to or failure to comply
      with these laws and regulations, or adoption of new laws and regulations, could
      adversely affect our business.





26




In
      the
      United States, as a manufacturer of medical devices and devices utilizing
      radioactive by-product material, we are subject to extensive regulation by
      federal, state, and local governmental authorities, such as the FDA and the
      Washington State Department of Health, **** to
      ensure
      such devices are safe and effective. Regulations promulgated by the FDA under
      the U.S. Food, Drug and Cosmetic Act, or the FDC Act, govern the design,
      development, testing, manufacturing, packaging, labeling, distribution,
      marketing and sale, post-market surveillance, repairs, replacements, and recalls
      of medical devices. In Washington State, the Department of Health, by agreement
      with the federal Nuclear Regulatory Commission ("NRC"), regulates the
      possession, use, and disposal of radioactive byproduct material as well as
      the
      manufacture of radioactive sealed sources to ensure compliance with state and
      federal laws and regulations. Our 131 Cs
      brachytherapy seeds constitute both medical devices and radioactive sealed
      sources and are subject to these regulations.




Under
      the
      FDC Act, medical devices are classified into three different categories, over
      which the FDA applies increasing levels of regulation: Class I,
      Class II, and Class III. Our 131 Cs
      seed
      has been classified as a Class II device and has received clearance from the
      FDA
      through the 510(k) pre-market notification process. Although not anticipated,
      any modifications to the device that would significantly affect safety or
      effectiveness, or constitute a major change in intended use, would require
      a new
      510(k) submission. As with any submittal to the FDA, there is no assurance
      that
      a 510(k) clearance would be granted to the Company.





In
      addition to FDA-required market clearances and approvals for our products,
      our
      manufacturing operations are required to comply with the FDA's Quality System
      Regulation, or QSR, which addresses requirements for a company's quality program
      such as management responsibility, good manufacturing practices, product and
      process design controls, and quality controls used in manufacturing. Compliance
      with applicable regulatory requirements is monitored through periodic
      inspections by the FDA Office of Regulatory Affairs ("ORA"). We anticipate
      both
      announced and unannounced inspections by the FDA. Such inspections could result
      in non-compliance reports (Form 483) which, if not adequately responded to,
      could lead to enforcement actions. The FDA can institute a wide variety of
      enforcement actions, ranging from public warning letters to more severe
      sanctions such as fines, injunctions, civil penalties, recall of our products,
      operating restrictions, suspension of production, non-approval or withdrawal
      of
      pre-market clearances for new products or existing products, and criminal
      prosecution. There can be no assurance that we will not incur significant costs
      to comply with these regulations in the future or that the regulations will
      not
      have a material adverse effect on our business, financial condition and results
      of operations.





The
      marketing of our products in foreign countries will, in general, be regulated
      by
      foreign governmental agencies similar to the FDA. Foreign regulatory
      requirements vary from country to country. The time and cost required to obtain
      regulatory approvals could be longer than that required for FDA clearance in
      the
      United States and the requirements for licensing a product in another country
      may differ significantly from FDA requirements. We will rely, in part, on
      foreign distributors to assist us in complying with foreign regulatory
      requirements. We may not be able to obtain these approvals without incurring
      significant expenses or at all, and the failure to obtain these approvals would
      prevent us from selling our products in the applicable countries. This could
      limit our sales and growth.




*Our
      Business Exposes Us To Product Liability Claims.* Our
      design, testing, development, manufacture, and marketing of products involve an
      inherent risk of exposure to product liability claims and related adverse
      publicity. Insurance coverage is expensive and difficult to obtain, and,
      although we currently have a five million dollar policy, in the future we may
      be
      unable to obtain or renew coverage on acceptable terms, if at all. If we are
      unable to obtain or renew sufficient insurance at an acceptable cost or if
      a
      successful product liability claim is made against us, whether fully covered
      by
      insurance or not, our business could be harmed.




27




*Our
      Business Involves Environmental Risks.* Our
      business involves the controlled use of hazardous materials, chemicals,
      biologics, and radioactive compounds. Manufacturing is extremely susceptible
      to
      product loss due to radioactive, microbial, or viral contamination; material
      or
      equipment failure; vendor or operator error; or due to the very nature of the
      product’s short half-life. Although we believe that our safety procedures for
      handling and disposing of such materials comply with state and federal standards
      there will always be the risk of accidental contamination or injury. In
      addition, radioactive, microbial, or viral contamination may cause the closure
      of the respective manufacturing facility for an extended period of time. By
      law,
      radioactive materials may only be disposed of at state-approved facilities.
      At
      our leased facility we use commercial disposal contractors. We may incur
      substantial costs related to the disposal of these materials. If we were to
      become liable for an accident, or if we were to suffer an extended facility
      shutdown, we could incur significant costs, damages, and penalties that could
      harm our business.




*We
      Rely Upon Key Personnel.* Our
      success will depend, to a great extent, upon the experience, abilities and
      continued services of our executive officers and key scientific personnel.
      IsoRay has an employment agreement with Roger Girard, its Chief Executive
      Officer, and its subsidiary has employment agreements with most of its executive
      officers and key scientific personnel. If we lose the services of several of
      these officers or key scientific personnel, our business could be harmed. Our
      success also will depend upon our ability to attract and retain other highly
      qualified scientific, managerial, sales, and manufacturing personnel and their
      ability to develop and maintain relationships with key individuals in the
      industry. Competition for these personnel and relationships is intense and
      we
      compete with numerous pharmaceutical and biotechnology companies as well as
      with
      universities and non-profit research organizations. We may not be able to
      continue to attract and retain qualified personnel.





*The
      Value Of Our Granted Patent, and Our Patents Pending, Is Uncertain.* Although
      our management strongly believes that our patent on the process for producing 131 Cs,
      our
      patent pending on the manufacture of the brachytherapy seed, our patent
      applications on additional methods for producing 131 Cs
      and
      other isotopes which have been filed, and anticipated future patent
      applications, which have not yet been filed, have significant value, we cannot
      be certain that other like-kind processes may not exist or be discovered, that
      any of these patents is enforceable, or that any of our patent applications
      will
      result in issued patents.





*Our
      Ability To Expand Into Foreign Markets Is Uncertain.* Our
      future growth will depend in part on our ability to establish, grow and maintain
      product sales in foreign markets, particularly in Europe and Asia. However,
      we
      have limited experience in marketing and distributing products in other
      countries. Any foreign operations would subject us to additional risks and
      uncertainties, including our customers’ ability to obtain reimbursement for
      procedures using our products in foreign markets; the burden of complying with
      complex and changing foreign regulatory requirements; language barriers and
      other difficulties in providing long-range customer service; potentially longer
      accounts receivable collection times; significant currency fluctuations, which
      could cause third-party distributors to reduce the number of products they
      purchase from us because the cost of our products to them could fluctuate
      relative to the price they can charge their customers; reduced protection of
      intellectual property rights in some foreign countries; and the possibility
      that
      contractual provisions governed by foreign laws would be interpreted differently
      than intended in the event of a contract dispute. Any future foreign sales
      of
      our products could also be adversely affected by export license requirements,
      the imposition of governmental controls, political and economic instability,
      trade restrictions, changes in tariffs and difficulties in staffing and managing
      foreign operations. Many of these factors may also affect our ability to import
      enriched barium from Russia under our contract with the Institute of Nuclear
      Materials. ****





*Our
      Ability To Initiate Operations And Manage Growth Is Uncertain.* Our
      efforts to commercialize our medical products will result in new and increased
      responsibilities for management personnel and will place a strain upon the
      entire company. To compete effectively and to accommodate growth, if any, we
      may
      be required to continue to implement and to improve our management,
      manufacturing, sales and marketing, operating and financial systems, procedures
      and controls on a timely basis and to expand, train, motivate and manage our
      employees. There can be no assurance that our personnel, systems, procedures,
      and controls will be adequate to support our future operations. If the IsoRay 131 Cs
      seed
      were to rapidly become the “seed of choice,” it is unlikely that we could meet
      demand. We could experience significant cash flow difficulties and may have
      difficulty obtaining the working capital required to manufacture our products
      and meet demand. This would cause customer discontent and invite competition.





28




*Our
      Reporting Obligations As A Public Company Are Costly.* Operating
      a public company involves substantial costs to comply with reporting obligations
      under federal securities laws that are continuing to increase as provisions
      of
      the Sarbanes Oxley Act of 2002 are implemented. These reporting obligations
      will
      increase our operating costs. We may not reach sufficient business volume to
      justify our public reporting status.





*There
      Is A Limited Market For Our Common Stock.* Currently
      only a limited trading market exists for our common stock. Our common stock
      currently trades on the Over-The-Counter Bulletin Board, a market with limited
      liquidity and minimal listing standards, under the symbol “ISRY.OB.” While
      management has plans to apply for listing on the American Stock Exchange, the
      Company currently does not meet the applicable requirements and is uncertain
      as
      to when it will be able to do so. Any broker/dealer that makes a market in
      our
      stock or other person that buys or sells our stock could have a significant
      influence over its price at any given time. Shareholders may experience more
      difficulty in attempting to sell their shares than if the shares were listed
      on
      a national stock exchange or quoted on the NASDAQ Stock Market. We cannot assure
      our shareholders that a market of our stock will be sustained. There is no
      assurance that our shares will have any greater liquidity than shares that
      do
      not trade on a public market.




*Our
      Stock Price Is Likely To Be Volatile.* There
      is
      generally significant volatility in the market prices and limited liquidity
      of
      securities of early stage companies, and particularly of early stage medical
      product companies. Contributing to this volatility are various events that
      can
      affect our stock price in a positive or negative manner. These events include,
      but are not limited to: governmental approvals, refusals to approve, regulations
      or actions; market acceptance and sales growth of our products; litigation
      involving the Company or our industry; developments or disputes concerning
      our
      patents or other proprietary rights; changes in the structure of healthcare
      payment systems; departure of key personnel; future sales of our securities;
      fluctuations in our financial results or those of companies that are perceived
      to be similar to us; investors’ general perception of us; and general economic,
      industry and market conditions. If any of these events occur, it could cause
      our
      stock price to fall.




*Our
      Common Stock Is Subject To Penny Stock Regulation.* As
      the
      market price of our shares has declined below $5.00 per share, our shares are
      now subject to the provisions of Section 15(g) and Rule 15g-9 of the Securities
      Exchange Act of 1934, as amended, commonly referred to as the “penny stock”
rule. Section 15(g) sets forth certain requirements for transactions in penny
      stocks and Rule 15g-9(d)(1) incorporates the definition of penny stock as that
      used in Rule 3a51-1 of the Exchange Act. The SEC generally defines penny stock
      to be any equity security that has a market price less than $5.00 per share,
      subject to certain exceptions. Rule 3a51-1 provides that any equity security
      is
      considered to be penny stock unless that security is: registered and traded
      on a
      national securities exchange meeting specified criteria set by the SEC;
      authorized for quotation on The NASDAQ Stock Market; issued by a registered
      investment company; excluded from the definition on the basis of price (at
      least
      $5.00 per share) or the Company’s net tangible assets; or exempted from the
      definition by the SEC. As our shares are now deemed to be “penny stocks”,
      trading in the shares are subject to additional sales practice requirements
      on
      broker-dealers who sell penny stocks to persons other than established customers
      and accredited investors. This classification also makes our shares ineligible
      for market coverage by many established brokerage firms.





29




**ITEM
      2 - DESCRIPTION OF PROPERTY**




Subsequent
      to June 2005, the Company’s executive offices are located at 350 Hills Street,
      Suite 106, Richland, WA 99354, (509) 375-1202, where IsoRay currently leases
      approximately 3,765 square feet of office and laboratory space for $5,144 per
      month from Energy Northwest. The lease expires December 31, 2006, but is
      renewable. The Company is not affiliated with its lessor. Additional office
      space will be needed as employees are hired, and is currently available at
      this
      location. The Company believes that its current facilities will be adequate
      until the end of fiscal year 2007, but it will need additional facilities at
      that time. In the future, due to business growth, the Company may elect to
      combine administrative services and production in one building which the Company
      may lease or build depending on market conditions.





We
      have
      entered into a lease, which commenced as of regulatory licensing approval on
      October 6, 2005, for a facility located in Richland, Washington that management
      believes will provide adequate space to manufacture the Cs-131 product for
      the
      prostate cancer markets until late 2007, with a maximum manufacturing capacity
      of approximately 60,000 seeds per month and total square footage of 4,400 feet.
      The lease is for a term of twelve months following regulatory licensing
      approval, with a twelve-month extension option. Payment for the initial lease
      term was the issuance of 24,007 shares of IsoRay, Inc. common stock. The lease
      may be extended on a month-to-month basis by mutual agreement of the parties.
      The lessor is Pacific EcoSolutions Incorporated (PEcoS), and the Company is
      not
      affiliated with this lessor. Equipment installed at this facility includes
      a hot
      cell, a glove box, three fume-hoods, laser welders and laser welding tooling,
      which complete the laser sealing of the seeds; sophisticated testing equipment
      that allows us to test materials used at several stages of the production
      process and assay the completed seeds prior to shipment; and sterilizing and
      packaging systems that allow the seeds to be pre-loaded into delivery systems
      according to customer specifications. We believe we will need to add to the
      capital production equipment installed at this facility within the next six
      to
      twelve months to meet increasing demand for our product, and have adequate
      room
      at the facility to install equipment that would approximately double the
      production capacity up to 60,000 seeds per month (approximately 600 patient
      treatments). If additional production space is needed it is available at the
      PEcoS facility.





The
      Company’s management believes that all facilities occupied by the Company are
      adequate for present requirements, and that the Company’s current equipment is
      in good condition and is suitable for the operations involved.





**ITEM
      3 - LEGAL PROCEEDINGS**





The
      Company is not involved in any material legal proceedings.





**ITEM
      4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**





No
      matter
      was submitted to a vote of the Company’s security holders during the fourth
      quarter of the fiscal year covered by this Annual Report.





**PART
      II**





**ITEM
      5 - MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDERS’
MATTERS**





The
      Company’s Articles of Incorporation provide that the Company has the authority
      to issue 200,000,000 shares of capital stock, which are currently divided into
      two classes as follows: 194,000,000 shares of common stock, par value of $0.001
      per share; and 6,000,000 shares of preferred stock, par value of $0.001 per
      share. As of September 18, 2006, we had 15,802,394 outstanding shares of Common
      Stock and 122,543 outstanding shares of Preferred Stock.





Our
      common stock is quoted on the OTC Bulletin Board under the symbol "ISRY.OB"
      and
      on the Pink Sheets under the symbol "ISRY.PK." There is limited trading activity
      in our securities, and there can be no assurance a regular trading market for
      our common stock will be sustained. We resumed trading on the Pink Sheets on
      August 18, 2005, after a period of no trading activity from February 18, 2005
      until August 18, 2005. We also had a period of no trading activity from July
      2003 until February 7, 2005. On November 2, 2005, we began trading on the OTC
      Bulletin Board. The following table sets forth, for the calendar periods
      indicated, the range of the high and low last reported bid prices of our common
      stock from October 1, 2003 through December 31, 2005, as reported by the Pink
      Sheets and the OTC Bulletin Board.  The quotations represent inter-dealer
      prices without retail mark-ups, mark-downs or commissions, and may not
      necessarily represent actual transactions.  The quotations may be rounded
      for presentation. There is an absence of an established trading market for
      the
      Company's common stock, as the market is limited, sporadic and highly volatile,
      which may affect the prices listed below.





30




The
      following table sets forth, for the fiscal quarters indicated, the high and
      low
      sales prices for our common stock as reported on the OTC Bulletin Board and
      the
      Pink Sheets.





**Year
                ended June 30, 2006**
            
            **High**
            
            **Low**First
                quarter
            
            $
            5.95
            
            $
            1.00Second
                quarter
            
            
            8.25
            
            
            4.50Third
                quarter
            
            
            7.25
            
            
            6.20Fourth
                quarter
            
            
            6.40
            
            
            3.25**Year
                ended June 30, 2005**
            
            
            **High**
            
            
            **Low**First
                quarter
            
            $
            N/A
            
            $
            N/ASecond
                quarter
            
            
            *
            
            
            *Third
                quarter(1)
            
            
            N/A
            
            
            N/A





*
            Less
                than $0.01.


(1)
            Due
                to our change of fiscal year end from September 30 to June 30, our
                2005
                fiscal year was only nine months
                long.





The
      Company has never paid any cash dividends on its Common Stock and does not
      plan
      to pay any cash dividends in the foreseeable future.





As
      of
      September 15, 2006, we had approximately 890 shareholders of record, exclusive
      of shares held in street name.





Equity
      Compensation Plans





On
      May
      27, 2005, the Company adopted the 2005 Stock Option Plan (the “Option Plan”) and
      the 2005 Employee Stock Option Plan (the “Employee Plan”), pursuant to which it
      may grant equity awards to eligible persons. On August 15, 2006, the Company
      adopted the 2006 Director Stock Option Plan (the “Director Plan”) pursuant to
      which it may grant equity awards to eligible persons. The Option Plan allows
      the
      Board of Directors to grant options to purchase up to 1,800,000 shares of common
      stock to directors, officers, key employees and service providers of the
      Company, and the Employee Plan allows the Board of Directors to grant options
      to
      purchase up to 2,000,000 shares of common stock to officers and key employees
      of
      the Company. The Director Plan allows the Board of Directors to grant options
      to
      purchase up to 1,000,000 shares of common stock to directors of the Company.
      Options granted under all of the Plans have a ten year maximum term, an exercise
      price equal to at least the fair market value of the Company’s common stock
      (based on the trading price on the OTC Bulletin Board) on the date of the grant,
      and with varying vesting periods as determined by the Board.




31


As
      of
      June 30, 2006, the following options had been granted under the option
      plans.





**Plan
                Category**
            
            Number
                of securities to be issued on exercise of outstanding options, warrants
                and rights
              #
            
            Weighted-average
                exercise price of outstanding options, warrants, and rights
              $
            
            Number
                of securities remaining available for future issuance under equity
                compensation plansEquity
                compensation plans approved by shareholders
            
            
            N/A
            
            
            N/A
            
            
            N/AEquity
                compensation plans not approved by shareholders
            
            
            3,257,592
            
            $
            2.11
            
            
            333,982Total
            
            
            3,257,592
            
            $
            2.11
            
            
            333,982





Sales
      of Unregistered Securities





During
      the last fiscal year, the following sales of unregistered securities were
      completed by the Company and not previously reported:





·
            On
                October 6, 2005, the Company issued 24,007 shares of common stock
                to
                Nuvotec USA, Inc. as payment for one year’s lease of the PIRL facilities
                pursuant to the exemption from registration provided by Section 4(2)
                of
                the Securities Act.





In
      addition, during the last fiscal year, the following sales of unregistered
      securities were completed by IsoRay Medical, Inc. and not previously
      reported:





·
            Between
                January 31, 2005 and July 10, 2005, IsoRay Medical, Inc. sold
                approximately $4,137,875 in principal amount of 8% convertible debentures
                (less commissions of ten percent on securities placed by broker/dealers),
                in reliance on the exemption from registration provided by Rule 506
                of
                Regulation D of the Securities Act, that subsequent to the merger
                between
                the Company and IsoRay Medical, Inc. were convertible into 995,882
                shares
                of common stock of the Company. On December 13, 2005, the Board of
                Directors of the Company announced a short-term conversion inducement
                to
                current holders of these convertible debentures. Holders were permitted
                two conversion options: 1) convert under the original terms of the
                debenture to the Company’s common stock at a $4.15 conversion price, and
                include the newly issued shares in the Company’s registration statement on
                Form SB-2, or 2) convert under terms essentially identical to those
                offered to purchasers of Units in the Company’s October 2005 Offering: a
                $4.00 conversion price and one callable warrant to purchase one share
                of
                the Company's common stock at an exercise price of $6.00 per share
                for
                each share issued upon conversion (waiving registration rights for
                approximately one year). Holders of $3,682,875 of debentures converted
                to
                common stock of the Company. The Company issued 911,276 shares of
                common
                stock, and 659,469 warrants to purchase shares of common stock,
                exercisable at $6.00 per share, leaving $455,000 in principal amount
                of
                debentures unconverted. Of the 911,276 shares of common stock issued
                pursuant to conversion of the debentures, 251,800 shares were included
                in
                the Company’s Form SB-2 filing (file number 333-129646) which became
                effective on June 8, 2006.





**ITEM
      6 - MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF
      OPERATION**





**Critical
      Accounting Policies and Estimates**





The
      discussion and analysis of the Company’s financial condition and results of
      operations are based upon its consolidated financial statements, which have
      been
      prepared in accordance with accounting principles generally accepted in the
      United States of America. The preparation of these financial statements requires
      management to make estimates and judgments that affect the reported amounts
      of
      assets, liabilities, revenues and expenses, and related disclosure of contingent
      liabilities. On an on-going basis, management evaluates past judgments and
      estimates, including those related to bad debts, inventories, accrued
      liabilities, and contingencies. Management bases its estimates on historical
      experience and on various other assumptions that are believed to be reasonable
      under the circumstances, the results of which form the basis for making
      judgments about the carrying values of assets and liabilities that are not
      readily apparent from other sources. Actual results may differ from these
      estimates under different assumptions or conditions.





32




The
      Company believes the following critical accounting policies affect its more
      significant judgments and estimates used in the preparation of its consolidated
      financial statements.





*Accounts
      Receivable*





Accounts
      receivable are stated at the amount that management of the Company expects
      to
      collect from outstanding balances. Management provides for probable
      uncollectible amounts through an allowance for doubtful accounts. Additions
      to
      the allowance for doubtful accounts are based on management’s judgment,
      considering historical write-offs, collections and current credit conditions.
      Balances which remain outstanding after management has used reasonable
      collection efforts are written off through a charge to the allowance for
      doubtful accounts and a credit to the applicable accounts receivable. Payments
      received subsequent to the time that an account is written off are considered
      bad debt recoveries.





*Inventory*





Inventory
      is reported at the lower of cost, determined using the weighted average method,
      or net realizable value.





*Asset
      Retirement Obligation*





SFAS
      No.
      143, *Asset
      Retirement Obligations* ,
      establishes standards for the recognition, measurement and disclosure of legal
      obligations associated with the costs to retire long-lived assets. Accordingly,
      under SFAS No. 143, the fair value of the future retirement costs of the
      Company’s leased assets are recorded as a liability on a discounted basis when
      it is incurred and an equivalent amount is capitalized to property and
      equipment. The initial recorded obligation, which has been discounted using
      the
      Company’s credit-adjusted risk free-rate, will be reviewed periodically to
      reflect the passage of time and changes in the estimated future costs underlying
      the obligation. The Company amortizes the initial amount capitalized to property
      and equipment and recognizes accretion expense in connection with the discounted
      liability over the estimated remaining useful life of the leased
      assets.





*Revenue
      Recognition*





The
      Company applies the provisions of SEC Staff Accounting Bulletin (“SAB”)
      No. 104, *Revenue
      Recognition* .
      SAB
      No. 104, which supersedes SAB No. 101, *Revenue
      Recognition in Financial Statements* ,
      provides guidance on the recognition, presentation and disclosure of revenue
      in
      financial statements. SAB No. 104 outlines the basic criteria that must be
      met to recognize revenue and provides guidance for the disclosure of revenue
      recognition policies. The Company recognizes revenue related to product sales
      when (i) persuasive evidence of an arrangement exists, (ii) shipment
      has occurred, (iii) the fee is fixed or determinable, and
      (iv) collectibility is reasonably assured.




Revenue
      for the fiscal years ended June 30, 2006 and 2005 was derived solely from sales
      of the 131 Cs
      brachytherapy seed, which is used in the treatment of cancer. The Company
      recognizes revenue once an order has been received and shipped to the customer.
      Prepayments, if any, received from customers prior to the time that products
      are
      shipped are recorded as deferred revenue. In these cases, when the related
      products are shipped, the amount recorded as deferred revenue is recognized
      as
      revenue. The Company accrues for sales returns and other allowances at the
      time
      of shipment.





33




*Legal
      Contingencies*





In
      the
      ordinary course of business, the Company is involved in legal proceedings
      involving contractual and employment relationships, product liability claims,
      patent rights, and a variety of other matters. The Company records contingent
      liabilities resulting from asserted and unasserted claims against it, when
      it is
      probable that a liability has been incurred and the amount of the loss is
      reasonably estimable. The Company discloses contingent liabilities when there
      is
      a reasonable possibility that the ultimate loss will exceed the recorded
      liability. Estimating probable losses requires analysis of multiple factors,
      in
      some cases including judgments about the potential actions of third-party
      claimants and courts. Therefore, actual losses in any future period are
      inherently uncertain. Currently, the Company does not believe any of its pending
      legal proceedings or claims will have a material impact on its financial
      position or results of operations. However, if actual or estimated probable
      future losses exceed the Company’s recorded liability for such claims, it would
      record additional charges as other expense during the period in which the actual
      loss or change in estimate occurred.





**Results
      of Operations**





Financial
      Presentation





Statement
      of Financial Accounting Standards (SFAS) No. 141, *Business
      Combinations* ,
      requires that following a merger the accounting acquirer’s financial statements
      should be used for historical comparisons. Although the legal acquirer was
      Century, for accounting purposes Medical was the acquirer and as such Medical’s
      historical financial statements are shown for comparative purposes. Also for
      accounting purposes, the merger was accounted for as though it happened on
      July
      1, 2005.





The
      following sets forth a discussion and analysis of the Company’s financial
      condition and results of operations for the two years ended June 30, 2006.
      This
      discussion and analysis should be read in conjunction with our consolidated
      financial statements appearing elsewhere in this Annual Report on
      Form 10-KSB. The following discussion contains forward-looking statements.
      Our actual results may differ significantly from the results discussed in such
      forward-looking statements. Factors that could cause or contribute to such
      differences include, but are not limited to, those discussed in
“Item 1 — Risk Factors” of this Annual Report on
      Form 10-KSB.





Year
      ended June 30, 2006 compared to year ended June 30, 2005





**Product
      sales.** Revenues
      for the year ended June 30, 2006 were $1,994,306, an increase of $1,792,575
      over
      sales for the year ended June 30, 2005 of $201,731. All of the Company’s
      revenues were generated through sales of its 131 Cs
      seeds.
      IsoRay began sales of its 131 Cs
      seed
      on October 26, 2004 with one medical center customer. By June 30, 2006 the
      number of medical center customers who had ordered the 131 Cs
      seed
      had grown to 26.





**Gross
      loss.** Gross
      loss was $1,820,816 for the year ended June 30, 2006 or an increase of $548,296
      as compared to a gross loss of $1,272,520 for the year ended June 30,
      2005.  Cost of products sold was $3,815,122 for the year ended June 30,
      2006 or an increase of $2,340,871 over the $1,474,251 incurred for the year
      ended June 30, 2005. During the year ended June 30, 2006, the Company paid
      $868,650 to Pacific Northwest National Laboratory (PNNL) under our contract
      with
      them for use of their facilities and personnel to support production. During
      the
      fourth quarter of fiscal year 2006, we paid approximately $110,000 for quality
      assurance support and as a deposit to extend our contract through December
      31,
      2007. The Company is currently using PNNL for certain research and development
      and quality assurance activities. Also during fiscal 2006, the Company paid
      approximately $1 million in wages, benefits, and related taxes for production
      personnel and approximately $1.6 million in direct and indirect material costs.
      These costs increased due to a larger staff and material and supply costs
      related to an increase in sales during fiscal year 2006.





34




Also
      included in cost of products sold during 2006 were over $109,000 for production
      and small tools, none of which individually exceeded the $2,500 threshold we
      use
      in determining whether to capitalize production equipment. These materials
      and
      small tools were needed to commence production in our independent production
      facility, the PEcoS-IsoRay Radioisotope Laboratory (“PIRL”). Most are long-lived
      items and will not need replacing in the next fiscal year. The Company has
      moved
      essentially all of its Cs-131 production operations to PIRL.





**Research
      and development.** Research
      and development expenses for the year ended June 30, 2006 were $450,425 an
      increase of $312,893 over research and development expenses of $137,532 for
      the
      year ended June 30, 2005. During 2006, $116,200 was spent on protocol studies
      of
      patients that have been implanted with the Company’s 131 Cs
      brachytherapy seeds. Also during 2006, $144,588 was spent on research to improve
      Cs-131 production.





**Sales
      and marketing expenses.** Sales
      and marketing expenses were $1,420,500 for the year ended June 30, 2006. This
      represents an increase of $718,678 over the expense of $701,822 for the year
      ended June 30, 2005. During fiscal 2006, approximately $994,000 was spent on
      wages, travel, office, and other support expenses on behalf of the sales and
      marketing and customer service staff. The balance was spent on advertising,
      market research and trade shows and conferences. The increases are due to
      increased marketing of the Company’s 131 Cs
      seed
      since introduction of our product to the market in October 2004.





**General
      and administrative expenses.** General
      and administrative expenses were $3,503,522 for the year ended June 30, 2006
      or
      an increase of $1,632,197 as compared to $1,871,325 for the year ended June
      30,
      2005. Included in general and administrative expenses in 2006 is $330,000
      relating to consulting fees for the reverse acquisition that was paid with
      the
      issuance of common stock (see Item 1). The
      increases over the prior periods are due to supporting the Company’s increased
      manufacturing and sales activities. These activities have increased as the
      Company has only been manufacturing and selling its product since October 2004.
      Additionally, increased expenses in the 2006 fiscal year were due to compliance
      with SEC regulations following the July 28, 2005 merger. Significant components
      of general and administrative expenses include $838,797 in consulting expense,
      payroll and related expenses of $866,863 and professional fees, including
      accounting and legal fees of $522,318. Consulting services increased in connection with the establishment of the
      independent PIRL production facilities, which commenced production in the late
      Fall of 2005, and associated equipment installation, customization and
      validation; review and advice on business and capital strategies, and the
      addition of a medical director who serves as a consultant. Professional
      fees increased due to the Company’s July 28, 2005 merger, SEC compliance
      activities including the Company’s registration statement on Form SB-2 filed
      that was effective in June 2006, and other general business activities.





**Operating
      loss.** Due to
      the Company’s significant research and develop expenditures, additional
      responsibilities as a reporting company, rapid structural growth, and nominal
      product revenues, the Company has not been profitable, and has generated
      operating losses since inception. For the year ended June 30, 2006, the Company
      had an operating loss of $7,195,263. This represents an increased loss of
      $3,212,064 in comparison with the year ended June 30, 2005 operating loss of
      $3,983,199.





**Interest
      income.** Interest
      income increased by $49,350 to $51,744 for the year ended June 30, 2006.
      Interest income is mainly derived from excess funds held in certain near-liquid
      accounts.





**Financing
      expense.** Financing expense for the year ended June 30, 2006 includes $332,493 of interest
      expense incurred on long-term debt and convertible debentures outstanding.
      The
      interest expense increased over the prior year due to interest payments on
      the
      convertible debentures that were sold as part of the January 1, 2005 PPM,
      computed interest expense on the capital leases entered into during fiscal
      2006,
      and interest expense on other loans that were initiated in January 2005. The
      remaining balance of financing expense represents amortization of deferred
      financing costs primarily related to the January 2005 issuance of common stock
      to guarantors of certain loans made to the Company, commissions and legal costs
      paid in conjunction with the issuance of convertible debentures, issuance of
      warrants as an inducement for a note payable, and costs associated with the
      initiation of the Hanford Area Economic Investment Fund Committee (HAEIFC)
      note
      payable. During 2006, $89,516 of deferred financing costs were expensed relating
      to debentures that were converted to common stock.





35




**Debt
      conversion expense.** This
      amount of approximately $385,000 relates to the one-time, non-cash expense
      resulting from the short-term inducement offered to debenture holders to their
      convert debentures to common stock (see Note 11). This expense was recognized
      in
      accordance with Statement of Financial Accounting Standard No. 84, *Induced
      Conversions of Convertible Debt* .





Year
      ended June 30, 2005 compared to year ended June 30, 2004





**Product
      sales.** Revenues
      for the year ended June 30, 2005 were $201,731. The Company did not have any
      revenues for the year ended June 30, 2004. IsoRay began sales of its 131 Cs
      seed
      on October 26, 2004 with one medical center customer. All of the Company’s sales
      in 2005 were generated through sales of its 131 Cs
      seeds.





**Gross
      loss.** Gross
      loss was $1,272,520 and cost of products sold was $1,474,251 for the year ended
      June 30, 2005. The Company did not have any gross loss or cost of products
      sold
      for the year ended June 30, 2005. During the year ended June 30, 2005, the
      Company paid $574,225 to Pacific Northwest National Laboratory (PNNL) under
      our
      contract with them for use of their facilities and personnel to support
      production. The Company was using PNNL for production of its seeds and other
      activities.





**Research
      and development.** Research
      and development expenses for the year ended June 30, 2005 were $137,532 an
      increase of $95,206 over research and development expenses of $42,326 for the
      year ended June 30, 2004. The change is due to research to improve Cs-131
      production and of other isotopes.





**Sales
      and marketing expenses.** Sales
      and marketing expenses were $701,822 for the year ended June 30, 2005. This
      represents an increase of $620,336 over the expense of $81,486 for the year
      ended June 30, 2004. Most of the 2005 expenses were spent on wages, travel,
      office, and other support expenses on behalf of the sales and marketing and
      customer service staff. The increases are due to hiring sales personnel during
      2005 to market the Company’s 131 Cs
      seed
      which was only introduced to the market in October 2004.





**General
      and administrative expenses.** General
      and administrative expenses were $1,871,325 for the year ended June 30, 2005
      as
      compared to $650,161 for the year ended June 30, 2004. The increase is due
      to
      increased salaries for officers who were foregoing salaries or were paid under
      market and the hiring of additional staff as the Company began manufacturing
      and
      selling its product. Approximately $870,000 was spent on payroll, benefits,
      and
      related employment costs during fiscal year 2005. Other significant components
      of general and administrative expenses included about $178,000 in consulting
      services and $269,000 of professional fees. Consulting expenses increased as
      the
      Company hired advisors for operations, business and capital strategies.
      Professional fees increased due to the merger of the two predecessor companies
      into IsoRay Medical, Inc. as well as the Company’s private placements and other
      general business matters.





36




**Operating
      loss.** Due to
      the Company’s significant research and development expenditures, large general
      and administrative expenses and payroll related to properly staffing the Company
      for anticipated further growth coupled with nominal product revenues, the
      Company generated operating losses. For the year ended June 30, 2005, the
      Company had an operating loss of $3,983,199. This represents an increased loss
      of $3,209,226 in comparison with the year ended June 30, 2004 operating loss
      of
      $773,973.





**Interest
      income.** Interest
      income was $2,394 for the year ended June 30, 2005 which was an increase of
      $496
      over interest income of $1,898 for the year ended June 30, 2004.





**Financing
      expense.** Financing expense for the year ended June 30, 2005 includes amortization of
      deferred financing costs and interest expense incurred on long-term debt and
      convertible debentures outstanding. The deferred financing costs relate
      primarily to the January 2005 issuance of common stock to guarantors of certain
      loans made to the Company and commissions and legal costs paid in conjunction
      with the issuance of convertible debentures. Amortization of these costs
      amounted to $76,746 during 2005. The remaining balance relates to interest
      expense which increased due to the issuance of the convertible debentures in
      2005.





**Loss
      on disposal of fixed assets.** This
      loss in 2005 relates to the write-off of certain rudimentary production
      equipment that was replaced by complex production equipment that improves the
      manufacturing process.





**Liquidity
      and capital resources.** At June
      30, 2006, cash and cash equivalents amounted to $2,207,452. During the year
      ended June 30, 2006, the Company issued 1,768,889 shares of common stock
      pursuant to two private placements, which raised $6,516,350 of cash, net of
      legal costs and commissions paid. Additionally, the Company issued 666,691
      shares of common stock pursuant to the exercise of common stock options and
      warrants and preferred stock warrants, which were exchanged for common stock
      immediately upon exercise. These option and warrant exercises were paid in
      cash
      and by surrendering a partial note payable. The Company received $1,400,114
      in
      cash and forgiveness of $48,313 of notes payable pursuant to these exercises.
      During 2006, the Company exchanged $3,682,875 of convertible debentures for
      911,271 common shares and 659,469 warrants. This conversion allowed the Company
      to alleviate approximately $3.68 million of indebtedness at a favorable equity
      exchange rate. The Company also issued 207,479 shares of common stock for
      $515,035 of consulting services, production equipment repair and maintenance,
      production equipment, and production rent.





On
      August
      17, 2006, the Company closed a round of institutional funding that provided
      approximately $5 million, net of offering costs. The Company issued 2,063,000
      shares of common stock at a price of $2.50 per share and 2,269,300 common stock
      warrants (including broker warrant commissions) with an exercise price of $3.00
      per share. The warrants have a call feature which the Company can trigger once
      the stock trades above $4.50 per share for a specified period of
      time.





The
      Company had approximately $5.9 million of cash on hand as of September 1, 2006.
      As of that date management believes that the Company’s monthly required cash
      operating expenditures were approximately $800,000. This recent increase in
      monthly expenditures is primarily a result of the addition of various protocols
      for seed applications and the obsolescence of the Company’s oversupply of Cesium
      resulting from an inability to forecast demand after the slower than anticipated
      months of July and August. Management is focused on achieving better forecasting
      demand models to alleviate loss of viable seeds due to a half life which results
      in quick obsolescence and believes that increases in demand will lessen the
      impact of overoptimistic forecasts. The Company has issued purchase orders
      for
      additional production equipment that will allow it to expand production capacity
      in its current facility. The total of these purchase orders is approximately
      $260,000 and it is anticipated that about $225,000 of this equipment will be
      funded with the HAEIFC loan. As of September 1, 2006, management believes that
      assuming expenditures continue at approximately the same monthly rate and that
      it is able to fund a portion of its equipment purchases with the HAEIFC loan
      that the Company’s cash on hand will fund operating expenditures through the
      beginning of March 2007. This is based on the Company attaining its current
      revenue targets and the ability to efficiently manufacture our product. If
      we
      should experience disruptions in our revenues then our monthly cash requirements
      would increase and necessitate that we obtain additional funding prior to March
      2007.




37




Our
      growth plans for fiscal 2007 include expanding sales to new customers, growing
      sales volume with existing customers, and expanding production capability
      through the purchase of additional equipment. The Company has also begun a
      review of its current facilities and future needs. The Company continues to
      use
      PNNL to provide third-party assay of its products, but has otherwise vacated
      PNNL facilities. This review includes evaluating the Company’s need for space
      given its growth projections. It is anticipated that additional employees and
      production equipment will be needed to meet future growth. This could create
      the
      need for additional production and office space that would be leased through
      an
      operating lease.





IsoRay
      has four loans outstanding as of June 30, 2006. The first from Tri-City
      Industrial Development Council, with an original principal amount of $40,000,
      was funded in 2001 and required a final principal-only payment of $10,000 which
      was paid in August 2006. It was non-interest bearing and unsecured. The second
      loan is from the Benton-Franklin Economic Development District (“BFEDD”) in an
      original principal amount of $230,000 and was funded in December 2004. It bears
      interest at eight percent and has a sixty month term with a final balloon
      payment. As of June 30, 2006, the principal balance owed was $204,237. This
      loan
      is secured by certain equipment, materials and inventory of IsoRay, and also
      required personal guarantees, for which the guarantors were issued approximately
      70,455 shares of common stock. The third loan is a line of credit from Columbia
      River Bank, which provides credit in the amount $395,000. It bears interest
      at a
      floating prime plus two percent rate, and is secured by certain accounts
      receivable and inventory and personal guarantees, for which the guarantors
      were
      issued approximately 107,401 shares of common stock. As of June 30, 2006, no
      balance was outstanding on the line of credit. The line of credit expires on
      March 1, 2007. The fourth loan is from the Hanford Area Economic Fund Investment
      Committee and was originated in June 2006. The loan has a total facility of
      $1,400,000 and bears interest at nine percent. As of June 30, 2006, the Company
      has taken only a partial draw of $418,670 on the facility and the remaining
      facility of $981,330 is available to use to purchase equipment. This loan is
      secured by receivables, equipment, materials and inventory of IsoRay, and
      certain life insurance policies.





The
      BFEDD
      has granted IsoRay a waiver from enforcing violations of paying officers in
      excess of $100,000 per year and maintaining a certain current asset ratio.
      The
      waiver is effective through June 30, 2007 and also excuses non-compliance with
      covenants prohibiting fixed asset of lease obligations in excess of $24,000
      per
      year, covenants prohibiting mergers, and covenants requiring maintenance of
      a
      certain long-term debt to equity ratio. Management believes that if the BFEDD
      accelerates repayment that it has sufficient cash resources to satisfy this
      obligation.




The
      Company has certain capital leases for production and office equipment that
      expire at various times from March 2008 to April 2009. These leases currently
      call for total monthly payments of $19,361. The total of capital lease
      obligations at June 30, 2006 was $403,969.





At
      June
      30, 2006, the Company had outstanding $455,000 of convertible debentures. These
      debentures could be converted into 109,639 shares of common stock at a
      conversion rate of $4.15 per share. Each debenture bears interest at an annual
      rate of eight percent (not compounded) with accrued interest paid quarterly.
      The
      debentures mature at various times from February 2007 to June 2007.





Through
      September 1, 2006, the Company had issued purchase orders for approximately
      $260,000 of production and office equipment. The Company anticipates financing
      most of these purchases through the HAEIFC facility.





In
      February 2006, the Company signed a license agreement with International
      Brachytherapy s.a. (“IBt”) covering North America and providing the Company with
      access to IBt’s Ink Jet production process and its proprietary polymer seed
      technology for use in brachytherapy procedures using Cesium-131. The Company
      paid license fees of $275,000 during 2006 and another payment of $225,000 was
      to
      be made in August 2006 pursuant to the license agreement. Royalty payments
      based
      on net sales revenue are also required, with minimum quarterly royalties ranging
      from $100,000 to $200,000 and minimum annual royalties ranging from $400,000
      to
      $800,000 over the term of the agreement. Management is engaged in further
      negotiations with IBt and may ultimately terminate this agreement, although
      management has not yet decided on a course of action.





38




As
      of the
      date of this report, the August 2006 payment has not been made as the Company
      has been in continued negotiations with IBt concerning the amount and timing
      of
      future royalty payments due to the low market acceptance of the polymer seed
      technology.





In
      September 2006, the Company entered into a settlement agreement with a former
      executive. As part of the settlement the Company agreed to pay the former
      executive $100,000 in September 2006 and $215,000 in January 2007. As the former
      executive’s employment with the Company ended in March 2006, the full amount of
      both payments was accrued as of June 30, 2006 in accrued payroll.





The
      Company is subject to various local, state, and federal environmental
      regulations and laws due to the isotopes used to produce the Company’s product.
      As part of normal operations, amounts are expended to ensure that the Company
      is
      in compliance with these laws and regulations. While there have been no
      reportable incidents, the Company believes that were it to discontinue or
      relocate its current production facilities then certain remediation expenses
      would be incurred. Therefore, the Company has established an initial asset
      retirement obligation of $63,040 which represents the discounted cost of cleanup
      that the Company anticipates it will have to incur at the end of its equipment
      leases. This amount was determined based on discussions with qualified
      production personnel and on historical evidence. The Company does not believe
      that any amount of this accrual will be spent during fiscal year
      2007.





The
      industry that the Company operates in is subject to product liability
      litigation. Through its production and quality assurance procedures, the Company
      works to mitigate the risk of any lawsuits concerning its product. The Company
      also carries product liability insurance to help protect it from this
      risk.





The
      Company expects to finance its future cash needs through the sale of equity
      securities, solicitation to warrant holders to exercise their warrants, and
      possibly strategic collaborations or debt financing or through other sources
      that may be dilutive to existing shareholders. If the Company needs to raise
      additional money to fund its operations, funding may not be available to it
      on
      acceptable terms, or at all. If the Company is unable to raise additional funds
      when needed, it may not be able to market its products as planned or continue
      development and regulatory approval of its future products. If the Company
      raises additional funds through equity sales, these sales may be dilutive to
      existing investors.





The
      Company has no off-balance sheet arrangements.





**Going
      Concern Issues**




Our
      financial statements have been prepared assuming we will continue as a going
      concern. We had net losses of $8,218,130 and $4,269,188 for the years ended
      June
      30, 2006 and 2005 and an accumulated deficit of $13,546,261 at June 30, 2006.
      These factors, among others, raise substantial doubt about our ability to
      continue as a going concern. Our financial statements do not include any
      adjustment that might result from the outcome of this uncertainty. Management
      plans to obtain the necessary financing and to continue to grow revenues in
      order to achieve profitability but no assurances can be given that management
      will be able to obtain additional financing or grow revenues to a profitable
      level.





If
      we are
      unable to generate profits and unable to obtain additional financing to meet
      our
      working capital requirements, we may have to curtail our business or cease
      operations. Our continuation as a going concern is dependent upon our ability
      to
      generate sufficient cash flow to meet our obligations on a timely basis, to
      obtain additional financing, and, ultimately, to attain profitability. Should
      any of these events not occur, the accompanying financial statements will be
      adversely effected and we may have to cease operations.





39




**Inflation**




Inflation
      and changing prices are not anticipated to have a significant impact on the
      future operations of the Company.





**Recent
      Accounting Pronouncements**





In
      December 2004, the FASB issued SFAS 123(Revised), *Share-Based
      Payment* (“SFAS 123R”), which replaces SFAS 123 and supersedes APB 25. On
      April 14, 2005, the Securities and Exchange Commission adopted a new rule
      that amends the compliance dates for SFAS 123R. Under the new rule, we are
      required to adopt SFAS 123R for the three-month period commencing
      July 1, 2006. SFAS 123R requires all share-based payments to
      employees, including grants of employee stock options, be recognized as
      compensation cost in the financial statements based on their fair values. As
      such, reporting employee stock options under the intrinsic value-based method
      prescribed by APB 25 will no longer be allowed. We have historically
      elected to use the intrinsic value method and have not recognized expense for
      employee stock options granted. We plan to adopt SFAS 123R on July 1,
      2006 on a prospective basis. Upon adoption, all future employee stock option
      grants plus the balance of the non-vested grants awarded prior to July 1,
      2006, will be expensed over the stock option vesting period based on the fair
      value at the date the options are granted. We estimate that the impact of
      adoption will be an additional expense of $189,430 for employee stock options
      granted prior to June 30, 2006.





In
      May
      2005, the FASB issued SFAS No. 154, *Accounting
      Changes and Error Corrections — A Replacement of APB Opinion No. 20
      and FASB Statement No. 3* (“SFAS 154”).
      SFAS 154 requires the retrospective application to prior periods’ financial
      statements of changes in accounting principle, unless it is impractical to
      determine either the period-specific effects or cumulative effect of the
      accounting change. SFAS No. 154 also requires that a change in
      depreciation, amortization, or depletion method for long-lived non-financial
      assets be accounted for as a change in accounting estimate affected by a change
      in accounting principle. SFAS No. 154 is effective for accounting
      changes and corrections of errors made in fiscal years beginning after
      December 15, 2005 and we will adopt this provision, as applicable, during
      fiscal year 2007.





**ITEM
      7 - FINANCIAL STATEMENTS**




The
      required accompanying financial statements begin on page F-1 of this
      document.




**ITEM
      8 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**





The
      Company’s Board of Directors engaged DeCoria, Maichel & Teague, P.S., the
      independent auditor for the Company's wholly-owned subsidiary, to be its new
      independent auditor effective November 15, 2005, which was also the effective
      date of S.W. Hatfield, CPA’s dismissal as the Company’s certifying accountant by
      the Board.




Except
      for an expression of doubt about our ability to continue as a going concern,
      S.W. Hatfield, CPA's audit reports on the Company’s financial statements as of
      June 30, 2005 and September 30, 2004 did not contain an adverse opinion or
      disclaimer of opinion, nor were they qualified or modified as to uncertainty,
      audit scope or accounting principles.




During
      the two fiscal years ended June 30, 2005 and September 30, 2004, and through
      November 15, 2005 there were no disagreements with S.W. Hatfield, CPA on any
      matter of accounting principles or practices, financial statement disclosure,
      or
      auditing scope or procedures, which disagreements, if not resolved to the
      satisfaction of S.W. Hatfield, CPA would have caused it to make a reference
      to
      the subject matter of the disagreements in connection with its report; and
      there
      were no reportable events as described in Item 304(a)(1)(iv)(B) of Regulation
      S-B promulgated by the Securities and Exchange Commission (the “SEC”) pursuant
      to the Securities Exchange Act of 1934, as amended.





40




During
      the Company’s two most recent fiscal years and through November 15, 2005, the
      Company did not consult DeCoria, Maichel & Teague, P.S. with respect to the
      application of accounting principles to a specified transaction, either
      completed or proposed, or the type of audit opinion that might be rendered
      on
      the Company’s financial statements, or any other matters or reportable events
      listed in Item 304(a)(2) of Regulation S-B. However, IsoRay Medical, Inc.,
      the
      Company's wholly-owned subsidiary, has consulted with DeCoria, Maichel &
Teague, P.S., its independent auditor, during these time periods solely in
      connection with IsoRay Medical, Inc.'s financial statements.




**ITEM
      8A - CONTROLS AND PROCEDURES**





(a) Under
      the supervision and with the participation of our management, including our
      principal executive officer and principal financial officer, we conducted an
      evaluation of the design and operation of our disclosure controls and
      procedures, as such term is defined under Rules 13a-14(c) and 15d-14(c)
      promulgated under the Securities Exchange Act of 1934, as amended (the "Exchange
      Act"), as of June 30, 2006. Based on that evaluation, our principal executive
      officer and our principal financial officer concluded that the design and
      operation of our disclosure controls and procedures were effective in timely
      alerting them to material information required to be included in the Company's
      periodic reports filed with the SEC under the Exchange Act. The design of any
      system of controls is based in part upon certain assumptions about the
      likelihood of future events, and there can be no assurance that any design
      will
      succeed in achieving its stated goals under all potential future conditions,
      regardless of how remote. However, management believes that our system of
      disclosure controls and procedure is designed to provide a reasonable level
      of
      assurance that the objectives of the system will be met.





(b) In
      connection with the review of our consolidated financial statements for the
      period ended September 30, 2005, our independent registered public accounting
      firm advised the Board of Directors and management of certain significant
      internal control deficiencies that they considered to be, in the aggregate,
      a
      material weakness. In particular, our independent registered public accounting
      firm identified the following weaknesses in our internal control system: (1)
      a
      lack of segregation of duties and (2) a lack of formal procedures relating
      to
      all areas of financial reporting. The independent registered public accounting
      firm indicated that they considered these deficiencies to be reportable
      conditions as that term is defined under standards established by the American
      Institute of Certified Public Accountants. A material weakness is a significant
      deficiency in one or more of the internal control components that alone or
      in
      the aggregate precludes our internal controls from reducing to an appropriately
      low level of risk that material misstatements in our financial statements will
      not be prevented or detected on a timely basis. The Company considered these
      matters in connection with the period end closing of accounts and preparation
      of
      the related consolidated financial statements and determined that no prior
      period financial statements were materially affected by such matters.
      Notwithstanding the material weaknesses identified by our independent registered
      public accountants, we believe that the financial statements and other financial
      information included in this report, fairly present in all material respects,
      the financial condition, results of operation and cash flows of the Company
      as
      of, and for, the periods represented in this report.





The
      size
      of the Company has previously prevented us from being able to employ sufficient
      resources at this time to enable us to have an adequate level of supervision
      and
      segregation of duties within our internal control system. Set forth below is
      a
      discussion of the significant internal control deficiencies that had not been
      remediated as of the end of the period covered by this report.





*Lack
      of segregation of duties.* Our size
      has prevented us from being able to employ sufficient resources to enable us
      to
      have an adequate level of segregation of duties within our internal control
      system. There is one dedicated employee and three employees that work in
      accounting and other departments who are involved in the processing of
      transactions. Due to the small employee base it is difficult to effectively
      segregate accounting duties. While we strive to segregate duties as much as
      practicable, budgetary considerations have not previously allowed the addition
      of full time staff. We are currently reorganizing the accounting department
      to
      more effectively segregate duties but we believe additional staff is still
      needed. We will continue in our attempt to add staff to allow for fuller
      segregation of duties, although there is no certainty additional staff can
      be
      successfully hired. As a result, this significant internal control deficiency
      has not been remediated as of the end of the period covered by this report,
      nor
      do we know if we will be able to remediate this weakness during the upcoming
      quarter.





41




*Lack
      of formal procedures relating to all areas of financial reporting including
      a
      lack of review by management.* Due to
      the size of our Company, and as a consequence of the lack segregation of duties,
      we have not previously had formal month end close procedures. As a result,
      there
      has been a lack of timely review of the financial statements. However, near
      the
      end of the fiscal year our controller began developing monthly close procedures
      and these were partially implemented at June 30, 2006. Although this significant
      internal control deficiency has not been fully remediated as of the end of
      the
      period covered by this report, we have made progress and expect to have this
      fully remediated by the end of the second quarter of fiscal year
      2007.





If
      we are
      unable to remediate the identified material weaknesses, there is a more than
      remote likelihood that a material misstatement to our SEC reports will not
      be
      prevented or detected, in which case investors could lose confidence in the
      accuracy and completeness of our financial reports, which could have an adverse
      effect on our ability to raise additional capital and could also have an adverse
      effect on our stock price.





**ITEM
      8B - OTHER INFORMATION**





There
      were no items required to be disclosed in a report on Form 8-K during the fourth
      quarter of the fiscal year ended June 30, 2006 that have not been properly
      disclosed on a Form 8-K filed with the SEC.





**PART
      III**




**ITEM
      9 - DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
      WITH SECTION 16(a) OF THE EXCHANGE ACT**





In
      conjunction with the Merger, and effective as of July 28, 2005 (the closing
      date
      of the Merger), Thomas Scallen resigned from his positions as Chief Executive
      Officer and Chairman of the Board, Philip Rogers resigned from his position
      as
      President and a director, and Wally Bietak resigned from his position as a
      director of the Company.





Effective
      as of July 28, 2005, Roger Girard and David Swanberg were appointed as directors
      by the resigning Board, and, also effective as of July 28, 2005, they appointed
      Robert Kauffman, Thomas LaVoy and Stephen Boatwright to fill the remaining
      three
      vacant Board positions. On March 31, 2006, the number of directors was increased
      to seven and Dwight Babcock and Albert Smith were appointed to fill the newly
      created positions.





The
      Board
      has established an Audit Committee consisting of Thomas LaVoy, (Chairman) and
      Robert Kauffman, and a Compensation Committee consisting of Dwight Babcock
      and
      Al Smith. No other committees have been formed.





The
      Audit
      Committee is responsible for assisting the Board of Directors in monitoring
      and
      oversight of (1) the integrity of the Company’s financial statements and its
      systems of internal accounting and financial controls and (2) the independence
      and performance of the Company’s independent auditors. The Board of Directors
      has determined that Mr. LaVoy and Mr. Kauffman are each an “audit
      committee financial expert” as defined in Item 401 of Regulation S-B promulgated
      by the Securities and Exchange Commission, and are each independent. The Board’s
      conclusions regarding the qualifications of Mr. LaVoy as an audit committee
      financial expert were based on his service as a chief financial officer of
      a
      public company, his experience as a certified public accountant and his degree
      in accounting. The Board’s conclusions regarding the qualifications of
      Mr. Kauffman as an audit committee financial expert were based on his
      service as a chief executive officer of multiple public companies, his active
      supervision of the principal financial and accounting officers of the public
      companies for which he served as chief executive officer, and his M.B.A. in
      Finance.





42




Effective
      as of July 28, 2005, Roger Girard was appointed as Chief Executive Officer
      and
      President of the Company and Michael Dunlop was appointed as Chief Financial
      Officer and Treasurer of the Company. Also effective July 28, 2005, John Hrobsky
      was appointed Vice President, Sales and Marketing and David Swanberg was
      appointed Secretary and Vice President-Operations.





In
      March
      2006, Mr. Hrobsky’s employment was terminated with the Company and in September
      2006 the Company reached a settlement agreement with him.





On
      September 7, 2006, Mr. Dunlop resigned from his position as Chief Financial
      Officer and Treasurer. Jonathan Hunt, formerly controller of the Company, was
      appointed as Chief Financial Officer and Treasurer of the Company on September
      7, 2006 to succeed Mr. Dunlop.





Further
      information about the current directors and officers may be found
      below.





The
      directors and executive officers serving the Company as of September 7, 2006
      were as follows:





Name
            
            Age
            
            Position
                Held
            
            Term*Roger
                Girard
            
            63
            
            Chairman,
                President, CEO
            
            AnnualJonathan
                Hunt
            
            39
            
            Chief
                Financial Officer - TreasurerDavid
                Swanberg
            
            50
            
            Executive
                Vice President - Operations and Corporate Secretary,
                Director
            
            AnnualRobert
                Kauffman
            
            65
            
            Director
            
            AnnualThomas
                LaVoy
            
            46
            
            Director
            
            AnnualStephen
                Boatwright
            
            42
            
            Director
            
            AnnualDwight
                Babcock
            
            58
            
            Director
            
            AnnualAlbert
                Smith
            
            62
            
            Director
            
            Annual




*
      For
      directors only





Roger
      Girard - In addition to serving as President, Chairman and CEO for the Company,
      Mr. Girard is also the CEO, President and Chairman of the Board of IsoRay
      Medical, Inc., and has served in these positions since the formation of IsoRay
      Medical, Inc. Mr. Girard was CEO and Chairman of IsoRay's predecessor company
      from August of 2003 until October 1, 2004. Mr. Girard has been actively involved
      in the management and the development of the management team at IsoRay, and
      his
      experienced leadership has helped drive IsoRay's development to date. From
      June
      1998 until August of 2003, Mr. Girard served as President of Strategic Financial
      Services, a business consulting company based in Seattle, Washington designed
      to
      help wealthy individuals and companies with strategic planning and financial
      strategy. Strategic Financial Services previously provided its services to
      a
      medical device company. Mr. Girard served as its sole employee. Mr. Girard
      also
      served as the managing partner for the Northwest office of Capital Consortium,
      another business consulting company based in Seattle, during this time. Capital
      Consortium employed four people and analyzed business market potential for
      start-ups and early stage companies. Mr. Girard has knowledge, experience and
      connections to private, institutional and public sources of
      capital and is experienced in managing and designing capital structures for
      business organizations as well as organizing and managing the manufacturing
      process, distribution, sales, and marketing, based on his 35 years of
      experience.





Jonathan
      Hunt - Mr. Hunt has over 10 years of finance and accounting experience,
      including financial reporting, SEC knowledge, and operational analysis. Before
      joining IsoRay earlier this year, he was employed by Hypercom Corporation,
      a
      global provider of electronic payment solutions and manufacturer of credit
      card
      terminals, serving as its Assistant Corporate Controller from 2005 to 2006.
      His
      finance background also includes serving as both a Manager and Director of
      Financial Reporting and a Director of Operational Planning and Analysis for
      Circle K Corporation and its affiliates from 2000 to 2005 and working for
      PricewaterhouseCoopers LLP from 1992 to 1999 where his last position held was
      Business Assurance Manager. Mr. Hunt holds Masters of Accountancy and Bachelor
      of Science degrees from Brigham Young University and is a Certified Public
      Accountant.




43




David
      Swanberg **-** Mr.
      Swanberg has more than 22 years experience in engineering and materials science,
      nuclear waste and chemical processing, aerospace materials and processes, and
      environmental technology development and environmental compliance. Beginning
      in
      November 1995 and until January 2004, Mr. Swanberg was employed full time as
      Sr.
      Chemical/Environmental Engineer for Science Applications International
      Corporation working on a variety of projects including nuclear waste research
      and development. Mr. Swanberg joined IsoRay's predecessor company in March
      of
      1999 on a part-time basis and has held management positions in the IsoRay
      companies since 2000. Mr. Swanberg began full-time employment with IsoRay in
      February 2004. He has been instrumental in development of IsoRay's initial
      product, the Cs-131 brachytherapy seed, including interfaces with technical,
      regulatory, and quality assurance requirements. With IsoRay and its predecessor
      companies, he has managed the development and production of radioactive seeds
      to
      support testing to meet NRC and FDA requirements, provided technical guidance
      for characterization of the IsoRay seed to meet AAPM Task Group 43 protocols,
      and coordinated production and testing of non-radioactive seeds to conform
      to
      ISO standards for brachytherapy devices. He is President of the Nuclear Medicine
      Research Council. He holds an MS in Chemical Engineering, is a licensed Chemical
      Engineer, and a certified Level II Radiation Worker.




Robert
      Kauffman - Mr. Kauffman has served as Chief Executive Officer and Chairman
      of the Board of Alanco Technologies, Inc. (NASDAQ: ALAN), an Arizona-based
      information technology company, since July 1, 1998. Mr. Kauffman was
      formerly President and Chief Executive Officer of NASDAQ-listed Photocomm,
      Inc.,
      from 1988 until 1997 (since renamed Kyocera Solar, Inc.). Photocomm was the
      nation’s largest publicly owned manufacturer and marketer of wireless solar
      electric power systems with annual revenues in excess of $35 million. Prior
      to
      Photocomm, Mr. Kauffman was a senior executive of the Atlantic Richfield
      Company (ARCO) whose varied responsibilities included Senior Vice President
      of
      ARCO Solar, Inc., President of ARCO Plastics Company and Vice President of
      ARCO
      Chemical Company. Mr. Kauffman earned an M.B.A. in Finance at the Wharton
      School of the University of Pennsylvania, and holds a B.S. in Chemical
      Engineering from Lafayette College, Easton, Pennsylvania.




Thomas
      LaVoy - Mr. LaVoy has served as Chief Financial Officer of SuperShuttle
      International, Inc., since July 1997 and as Secretary since March 1998.
      SuperShuttle is one of the largest providers of shuttle services in major cities
      throughout the West and Southwest regions of the United States. He has also
      served as a director of Alanco Technologies, Inc. (NASDAQ: ALAN) since 1998.
      From September 1987 to February 1997, Mr. Lavoy served as Chief Financial
      Officer of NASDAQ-listed Photocomm, Inc. Mr. Lavoy was a Certified Public
      Accountant with the firm of KPMG Peat Marwick from 1980 to 1983. Mr. Lavoy
      has a
      Bachelor of Science degree in Accounting from St. Cloud University, Minnesota,
      and is a Certified Public Accountant.





Stephen
      Boatwright - Mr. Boatwright has been a member of Keller Rohrback, PLC in
      Phoenix, Arizona since January 2005. From 1997 through January 2005,
      Mr. Boatwright was a partner at Gammage & Burnham, PLC, also in
      Phoenix, Arizona. Throughout his career, he has provided legal counsel to both
      private and public companies in many diverse industries. In recent years,
      Mr. Boatwright’s legal practice has focused on representing technology,
      biotechnology, life science and medical device companies for their securities,
      corporate and intellectual property licensing needs. Mr. Boatwright earned
      both a J.D. and an M.B.A. from the University of Texas at Austin, and holds
      a
      B.A. in Philosophy from Wheaton College.





44




Dwight
      Babcock - Mr. Babcock has served as Chairman and Chief Executive Officer of
      Apex
      Data Systems, Inc. an information technology company, since 1975. Apex Data
      Systems automates the administration and claims adjudication needs of insurance
      companies both nationally and internationally. Mr. Babcock was formerly
      President and CEO of Babcock Insurance Corporation (BIC) from 1974 until 1985.
      BIC was a nationally recognized Third Party Administrator operating within
      35
      states. Mr. Babcock has knowledge and experience in the equity arena and has
      participated in various activities within the venture capital, private and
      institutional capital markets. Mr. Babcock studied marketing and economics
      at
      the University of Arizona where he currently serves on the University of Arizona
      Astronomy Board.





Albert
      Smith - Mr. Smith was the co-founder of and served as Vice Chairman of CSI
      Leasing, Inc., a private computer leasing company from 1972 until March 2005.
      He
      founded Extreme Video, LLC a private video conferencing company in Scottsdale,
      Arizona in December 2005 where he presently serves as CEO and President. Mr.
      Smith presently serves as a director for Center for Arizona Policy (Scottsdale)
      and Doulos Ministries (Denver). Mr. Smith has extensive experience in marketing
      and sales having managed a national sales force of over fifty people while
      at
      CSI Leasing, Inc. Mr. Smith has a BS in Business Administration from Ferris
      State College.





The
      Company’s Directors, as named above, will serve until the next annual meeting of
      the Company’s stockholders or until their successors are duly elected and have
      qualified. Directors will be elected for one-year terms at the annual
      stockholders meeting. Officers will hold their positions at the pleasure of
      the
      board of directors, absent any employment agreement, of which none currently
      exists or is contemplated. There is no arrangement or understanding between
      any
      of the directors or officers of the Company and any other person pursuant to
      which any director or officer was or is to be selected as a director or officer,
      and there is no arrangement, plan or understanding as to whether non-management
      shareholders will exercise their voting rights to continue to elect the current
      directors to the Company’s board. There are also no arrangements, agreements or
      understandings between non-management shareholders that may directly or
      indirectly participate in or influence the management of the Company’s
      affairs.





There
      are
      no agreements or understandings for any officer or director to resign at the
      request of another person, and none of the officers or directors are acting
      on
      behalf of, or will act at the direction of, any other person.





Significant
      Employees




Certain
      significant employees of our subsidiary, IsoRay Medical, Inc., and their
      respective ages as of the date of this report are set forth in the table below.
      Also provided is a brief description of the experience of each significant
      employee during the past five years.




Name
            
            Age
            
            Position
                Held and TenureLane
                Bray
            
            78
            
            ChemistGarrett
                Brown
            
            43
            
            Chief
                Technology OfficerOleg
                Egorov
            
            36
            
            Director
                of Radiochemical DevelopmentLisa
                Mayfield
            
            37
            
            Director
                of OperationsKeith
                Welsch
            
            59
            
            Chief
                Quality OfficerLori
                Woods
            
            44
            
            Vice
                President




Lane
      Bray
      - Mr. Bray is known nationally and internationally as a technical expert in
      separations, recovery, and purification of isotopes and is a noted authority
      in
      the use of cesium and strontium ion exchange for Department of Energy’s West
      Valley and Hanford nuclear waste cleanup efforts. In 2000, Mr. Bray
      received the ’Radiation Science and Technology’ award from the American Nuclear
      Society. Mr. Bray has authored or co-authored over 110 research
      publications, 12 articles for 9 technical books, and holds 24 U.S. and foreign
      patents. Mr. Bray patented the USDOE/PNNL process for purifying medical
      grade Yttrium-90 that was successfully commercialized in 1999. Mr. Bray
      also recently invented and patented the proprietary isotope separation and
      purification process that is assigned to IsoRay. Mr. Bray was elected
’Tri-Citian of the Year’ in 1988, nominated for ’Engineer of the Year’ by the
      American Nuclear Society in 1995, and was elected ’Chemist of the Year for 1997’
by the American Chemical Society, Eastern Washington Section. Mr. Bray
      retired from the Pacific Northwest National Laboratory in 1998. Since retiring
      in 1998, Mr. Bray worked part time for PNNL on special projects until
      devoting all of his efforts to IsoRay in 2004. Mr. Bray has been a
      Washington State Legislator, a Richland City Councilman, and a Mayor of
      Richland. Mr. Bray has a B.A. in Chemistry from Lake Forest
      College.





45




Garrett
      Brown - Dr. Brown was Manager of Radiochemistry - Hot Cell Operations for
      International Isotopes, Inc., a major radiopharmaceutical and medical device
      startup company, from January 1998 until May 1999 and was instrumental in
      bringing a new brachytherapy seed implant device to commercialization.
      Dr. Brown’s responsibilities included hands-on radiological work in fume
      hoods, glove boxes and remote manipulator hot cells, process definition,
      research, development, installation, optimization, waste minimization, procedure
      documentation, facility design and training. Dr. Brown also served as the
      technical interface to executive management for business development,
      shipping/receiving, QA/QC, facilities and marketing/sales. Prior to that,
      Dr. Brown, as a Senior Research Scientist at the Pacific Northwest National
      Laboratory, was responsible for the weekly production of multi-Curie quantities
      of medical grade Y-90, and research programs to develop high tech sorbents
      for
      separation of Cs-137, Sr-90 and Tc-99 from high-level radioactive wastes stored
      at the Hanford Nuclear Reservation. From May 1999 to the present, Dr. Brown
      has been a technical consultant with GNB Technical Consultants. Dr. Brown
      has co-authored numerous technical publications in the field. Dr. Brown has
      a Ph.D. in Analytical Chemistry and BS in Chemistry, cum laude. He has served
      as
      IsoRay’s Chief Technical Officer since May of 2000. In March 2004,
      Dr. Brown was certified as a Radiological Safety Officer.





Oleg
      Egorov - Dr. Egorov is recognized nationally and internationally for his work
      in
      radiochemistry, radioanalytical chemistry, analytical chemistry and
      instrumentation. Prior to joining IsoRay in December of 2005 as Director of
      Radiochemical Development, Dr. Egorov worked from May 1998 as a Senior Research
      Scientist at the Pacific Northwest National Laboratory (PNNL). Prior to that
      time, he served the Environmental Molecular Sciences Laboratory at PNNL as
      a
      Graduate Research Fellow, from August 1994 to May 1998, and as a Graduate
      Research Assistant to the University of Washington’s Center for Process
      Analytical Chemistry from September 1992 to August 1993. Former positions
      included a tenure as a Research Engineer at the Department of Radiochemistry
      at
      the Moscow State University, Moscow, Russia between September 1998 to August
      1992, and Field Chemist at the Institute of Volcanology, at the Russian Academy
      of Science at Petropavlovsk-Kamchatsky, Russia, during the summers of 1989
      and
      1990 concurrent to studies that lead to his acquisition of Master of Science
      in
      Radiochemistry from the Moscow State University. During his tenure at PNNL,
      Dr.
      Egorov had led world-class basic and applied R&D programs directed at new
      chemistries and instrumentation for automated production of short-lived medical
      isotopes for the treatment of cancer, automated process monitoring, radionuclide
      sensors for groundwater monitoring, and laboratory automation. Dr. Egorov
      pioneered the application of flow-based techniques for automating radiochemical
      analyses of nuclear wastes, renewable surface sensing and separations, and
      equilibration-based radionuclide sensing. He has authored/co-authored numerous
      peer-reviewed publications in these areas, including several book chapters.
      Dr.
      Egorov holds four U.S./international patents, three of which have been licensed
      to industry. Dr. Egorov was a recipient of numerous outstanding performance
      and
      key contributor awards. In 2003, Dr. Egorov was nominated for the American
      Chemical Society Arthur F. Findeis Award for Achievements by a Young Analytical
      Scientist. In 2004, Dr. Egorov was a recipient of a Federal Laboratory
      Consortium Award for Excellence in Technology Transfer for “Alpha Particle
      Immunotherapy for Treating Leukemia and Solid-Tumor Metastases”. Dr. Egorov
      holds a M.S. in Radiochemistry from Moscow State University, Moscow, Russia;
      a
      M.S. in Environmental and Analytical Chemistry and a Ph.D. in Analytical
      Chemistry from the University of Washington.





Lisa
      Mayfield - Lisa Mayfield has over ten years of commercial healthcare sales,
      marketing and business development experience. Between December 1993 and August
      2004, Ms. Mayfield has held senior management positions in the pharmaceutical
      and medical device and diagnostics sectors of Johnson & Johnson as well as
      at J&J Corporate. During her time at J&J and prior to joining IsoRay in
      December 2005, Ms. Mayfield was responsible for implementing positive business
      results in over 11 different therapeutic markets. After leaving J&J and
      prior to joining IsoRay, Ms. Mayfield worked as a consultant to various
      healthcare companies in the radioisotope and oncology markets. As a result
      of
      her exposures, Ms. Mayfield has built a wealth of knowledge about the healthcare
      marketplace as a whole and complements this knowledge with a comprehensive
      understanding of internal operations. Ms. Mayfield has been responsible for
      best
      practices for product development, branding, forecasting, regulatory compliance,
      reimbursement and strategic planning. During her time at IsoRay, Ms. Mayfield
      has been able to successfully implement new policies and procedures that
      facilitate growth as well as provide top level guidance over strategic business
      operations. Ms. Mayfield is acting Director of Operations at IsoRay. Ms.
      Mayfield holds a Bachelors of Science in Economics from the University of
      Washington.





46




Keith
      Welsch - Mr. Welsch is a quality control professional with experience in a
      wide range of organizations and disciplines including the nuclear, aerospace,
      environmental restoration, construction, tubing, steel and aluminum industries.
      Mr. Welsch managed the registration of a plant to ISO 9002:1994 and
      subsequently transitioned the facility to ISO 9001:2000 and conducted continuous
      improvement actions. These included statistical process control, six sigma,
      lean
      manufacturing, and total preventive maintenance programs. Mr. Welsch’s
      other significant achievements include facilitation of quality improvement
      and
      stand down teams, innovative education training manager, management of records
      review for two nuclear sites, management of audit programs and corrective-action
      systems, and teaching safety, technical, and quality courses. He has earned
      the
      Certified Quality Auditor, Certified Quality Technician and Certified Quality
      Improvement Associate certifications from the American Society for Quality.
      Prior to joining IsoRay in 2004, Mr. Welsch served as Quality Assurance
      Manager for Kaiser Aluminum Products of Richland, Washington since 1997.
      Mr. Welsch received a BA in Business Administration from Washington State
      University.





Lori
      Woods - Ms. Woods joined the Company in July 2006 and has over 20 years
      experience in medical device technology and healthcare services. Ms. Woods
      served as the CEO of Pro-Qura, a medical services company focusing on
      brachytherapy quality assurance and education, from 2002 until joining the
      Company. During her tenure at Pro-Qura, Ms. Woods developed its business
      strategy, expanded its business portfolio in quality assurance beyond prostate
      brachytherapy into other areas of cancer, and increased funding by 50%. Prior
      to
      this, she served as the Vice President of Sales at ATI Medical in 2002, Vice
      President of Sales - West and Vice President of Marketing and Business
      Development for Imagyn Medical Technologies from 2000 to 2002, Director of
      Business Development for Seattle Prostate Institute from 1998 to 2000, and
      Regional Vice President and Regional Manager of Interdent from 1994 to 1998.
      Ms.
      Woods holds a Bachelor of Science degree in Business Administration - Marketing
      from Loma Linda University.





Section
      16(a) Beneficial Ownership Reporting Compliance




Section
      16(a) of the Securities Exchange Act of 1934 (the “Exchange Act”) requires the
      Company’s directors and executive officers, and persons who beneficially own
      more than ten percent of a registered class of our equity securities, to file
      with the Securities and Exchange Commission (the “Commission”) initial reports
      of beneficial ownership and reports of changes in beneficial ownership of our
      Common Stock. The rules promulgated by the Commission under Section 16(a) of
      the
      Exchange Act require those persons to furnish us with copies of all reports
      filed with the Commission pursuant to Section 16(a). The information in this
      section is based solely upon a review of Forms 3, Forms 4, and Forms 5 received
      by us.





We
      believe that IsoRay’s executive officers, directors and 10% shareholders timely
      complied with their filing requirements during the year ended June 30, 2006
      except as follows: Roger Girard (one Form 3), Robert Kauffman (one Form 3 and
      one Form 4), John Hrobsky (one Form 3), Karen Thompson (one Form 3), Stephen
      Boatwright (one Form 4), Thomas LaVoy (one Form 4), Michael Dunlop (one Form
      4),
      David Swanberg (one Form 4), Dwight Babcock (one Form 3 and one Form 4), and
      Albert Smith (one Form 3 and one Form 4). We believe all of these forms have
      been filed as of the date of this Report.





47




Code
      of Ethics




We
      have
      adopted a Code of Conduct and Ethics that applies to all of our officers,
      directors and employees and a separate Code of Ethics for Chief Executive
      Officer and Senior Financial Officers that supplements our Code of Conduct
      and
      Ethics. The Code of Conduct and Ethics was previously filed as Exhibit 14.1
      to
      our Form 10-KSB for the period ended June 30, 2006, and the Code of Ethics
      for
      Chief Executive Officer and Senior Financial Officers was previously filed
      as
      Exhibit 14.2 to this same report. The Code of Ethics for Chief Executive Officer
      and Senior Financial Officers is also available to the public on our website
      at
      http://www.isoray.com/ethicsForCeo.htm. Each of these policies comprises written
      standards that are reasonably designed to deter wrongdoing and to promote the
      behavior described in Item 406 of Regulation S-B promulgated by the Securities
      and Exchange Commission. Each of these policies was adopted after the period
      ended June 30, 2005.





**ITEM
      10 - EXECUTIVE COMPENSATION**




The
      following summary compensation table sets forth information concerning
      compensation for services rendered in all capacities during our past three
      fiscal years awarded to, earned by or paid to each of the following executive
      officers (the “Executive Officers”). None of the Company’s executive officers,
      other than those listed below, received compensation in fiscal year 2006 in
      excess of $100,000.


**Annual
                  Compensation**
              
              **Long-Term
                  Compensation Awards****Name
                  and Principal Position**
              
              **Fiscal
                  Year****(1)**
              
              **Salary**
              
              **Bonus**
              
              **Restricted
                  Stock Awards**
              
              **Securities
                  Underlying Options**
              
              **All
                  Other Compensation**Roger
                  Girard,
              
              
              2006
              
              $
              199,231
              
              
              —
              
              
              —
              
              
              —
              
              
              —Chief
                  Executive Officer(5)
              
              
              2005
              
              $
              113,958
              
              
              —
              
              
              —
              
              
              —
              
              
              —2004
              
              $
              71,031
              
              
              —
              
              $
              9,900
              
              
              513,840
              
              
              —Thomas
                  Scallen,
              
              
              2006
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —Former
                  Chief Executive Officer(2)
              
              
              2005
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              $
              50,000(3
              )2004
              
              
              —
              
              
              —
              
              $
              7,871(4
              )
              
              —
              
              
              —David
                  Swanberg,
              
              
              2006
              
              $
              120,000
              
              $
              25,000
              
              
              —
              
              
              150,000
              
              
              —Executive
                  Vice President -
              
              
              2005
              
              $
              54,746
              
              
              —
              
              
              —
              
              
              —
              
              
              —Operations
              
              
              2004
              
              $
              32,515
              
              
              —
              
              
              —
              
              
              —
              
              
              —Barry
                  Griffiths,
              
              
              2006
              
              $
              124,800
              
              $
              55,000
              
              
              —
              
              
              —
              
              
              —Former
                  Western Area Director
              
              
              2005
              
              $
              79,241
              
              $
              52,500
              
              
              —
              
              
              252,708
              
              
              —2004
              
              $
              15,000
              
              
              —
              
              
              —
              
              
              —
              
              
              —Curtis
                  Ellis,
              
              
              2006
              
              $
              168,115
              
              $
              39,125
              
              
              —
              
              
              84,236
              
              
              —Midwest
                  Area Director
              
              
              2005
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —2004
              
              
              —
              
              
              —
              
              
              —
              
              
              —
              
              
              —





(1)
            Fiscal
                year 2006 consisted of the period from July 1, 2005 to June 30, 2006;
                fiscal year 2005 consisted of the period from October 1, 2004 through
                June
                30, 2005; and, fiscal year 2004 consisted of the year ended September
                30,
                2004.


(2)
            Mr. Scallen
                served as our Chief Executive Officer during the listed fiscal years
                and
                until his resignation effective July 28,
                2005.


(3)
            Represents
                a $50,000 cash payment in June 2005 to Mr. Scallen in settlement of
                all accrued but unpaid
                compensation.


(4)
            Represents
                the issuance of 787,100 shares of restricted common stock as compensation
                associated with the conversion of the outstanding notes payable and
                accrued interest payable. This transaction was valued at approximately
                $7,781, which was equal to the “fair value” of the Company’s common stock
                on the conversion date. The Company relied upon Section 4(2) of the
                Securities Act of 1933, as amended, for an exemption from registration
                for
                this issuance.


(5)
            Mr.
                Girard did not begin serving as our CEO until July 28, 2005, but
                he has
                served as CEO of our subsidiary and its predecessor company since
                August
                2003. The compensation listed was paid to Mr. Girard by IsoRay or
                its
                predecessor company.




48


Option/SAR
      Grants in Last Fiscal Year




The
      following table sets forth information concerning grants of stock options to
      the
      Executive Officers during the fiscal year ended June 30, 2006.




**Name**
            
            **Number
                of Securities Underlying Options**
            
            **Percent
                of total options Granted to Employees in Fiscal
                Year**
            
            **Exercise
                Price ($/Share)**
            
            **Expiration
                Date**David
                Swanberg
            
            
            150,000
            
            
            23.45
            %
            $
            1.00
            
            
            8/18/2015Curtis
                Ellis
            
            
            84,236
            
            
            13.17
            %
            $
            4.15
            
            
            8/01/2015





Aggregated
      Option Exercises in Last Fiscal Year and Fiscal Year End Option
      Values




The
      following table sets forth the number of shares covered by unexercised stock
      options held by the Executive Officers as of June 30, 2006, and the value of
      "in-the-money" stock options, which represents the positive spread between
      the
      exercise price of a stock option or warrant and the market price of the shares
      subject to such option or warrant as of June 30, 2006 **.**





**Number
                  of Securities Underlying Unexercised Options at Fiscal
                  Year-End**
              
              **Value
                  of Unexercised In-the-Money Options at Fiscal
                  Year-End****Name**
              
              **Number
                  of Shares Acquired on Exercise**
              
              **Value
                  Realized**
              
              **Exercisable**
              
              **Unexercisable**
              
              **Exercisable**
              
              **Unexercisable**Roger
                  Girard
              
              
              0
              
              $
              0
              
              
              513,840
              
              
              0
              
              $
              1,186,970
              
              $
              N/ADavid
                  Swanberg
              
              
              0
              
              $
              0
              
              
              150,000
              
              
              0
              
              $
              375,000
              
              $
              N/ABarry
                  Griffiths
              
              
              0
              
              $
              0
              
              
              84,236
              
              
              168,472
              
              $
              194,585
              
              $
              389,170Curtis
                  Ellis
              
              
              0
              
              $
              0
              
              
              0
              
              
              84,236
              
              $
              N/A
              
              $
              N/A




***Employment
      Agreements***





The
      Company entered into an employment agreement with Roger Girard, its Chief
      Executive Officer, effective October 6, 2005 (the "Girard Agreement"). The
      term
      of the Girard Agreement is through October 6, 2009, and will automatically
      extend for an additional one year term on each anniversary date unless the
      term
      is modified or terminated in accordance with the terms of the Girard Agreement
      at least ninety days prior to a given anniversary date. The Girard Agreement
      provides for a base salary of $300,000 which was effective July 1, 2006. Mr.
      Girard is also entitled to participate in any benefit plans provided to key
      executives of the Company, and to a bonus at the discretion of the Board of
      Directors.





The
      Company has not entered into employment agreements with any other officers
      as of
      the date of this filing.





Director
      Compensation





Since
      July 28, 2005, we have paid our directors who are not employees of the Company
      a
      director’s fee of $1,000 per meeting attended, plus expenses. We also granted
      each non-employee director immediately exercisable options to purchase 100,000
      shares of our common stock during the fiscal year ended June 30, 2006. Robert
      Kauffman, Thomas LaVoy and Stephen Boatwright each received 100,000 options
      at
      an exercise price of $2.00 per share. Dwight Babcock and Al Smith each received
      100,000 options, 50,000 of which are exercisable at $6.30 per share and 50,000
      of which are exercisable at $3.80 per share.





The
      Company’s directors did not receive any cash compensation during the nine months
      ended June 30, 2005 or either of the respective years ended September 30, 2004
      or 2003.


49


**ITEM
      11 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
      MANAGEMENT**




The
      following tables set forth certain information regarding the beneficial
      ownership of the Company’s common stock and preferred stock as of September 15,
      2006 for (a) each person known by the Company to be a beneficial owner of five
      percent or more of the outstanding common or preferred stock of the Company,
      (b)
      each executive officer, director and nominee for director of the Company, and
      (c) directors and executive officers of the Company as a group. As of September
      15, 2006, the Company had 15,802,394 shares of common stock and 122,543 shares
      of preferred stock outstanding.





**Name
                and Address of Beneficial Owner****(1)**
            
            **Amount
                of Common Shares Owned**
            
            **Derivative
                Securities Exercisable or Convertible Within 60 Days of September
                15,
                2006**
            
            **Total
                Common Shares Beneficially Owned**
            
            **Percent
                of Common Shares Owned****(2)**Roger
                Girard, Chief Executive Officer, President and Chairman
            
            
            368,532
            
            
            513,840
            
            
            882,372
            
            
            5.41
            %Jonathan
                Hunt, Chief Financial Officer
            
            
            —
            
            
            —
            
            
            —
            
            
            —
            %Michael
                Dunlop, Former Chief Financial Officer
            
            
            138,050
            
            
            145,000
            
            
            283,050
            
            
            1.77
            %David
                Swanberg, Executive Vice President and Director
            
            
            324,327
            
            
            150,000
            
            
            474,327
            
            
            2.97
            %Robert
                Kauffman, Director
            
            
            43,802
            
            
            150,000
            
            
            193,802
            
            
            1.21
            %Thomas
                LaVoy, Director
            
            
            8,423
            
            
            150,000
            
            
            158,423
            
            
            0.99
            %Stephen
                Boatwright, Director(3)
            
            
            —
            
            
            234,236
            
            
            234,236
            
            
            1.46
            %Dwight
                Babcock, Director(4)
            
            
            42,403
            
            
            150,000
            
            
            192,403
            
            
            1.21
            %Albert
                Smith, Director
            
            
            108,947
            
            
            150,000
            
            
            258,947
            
            
            1.62
            %Thomas
                K. Scallen, Former Chief Executive Officer(5)
            
            
            317,442
            
            
            —
            
            
            317,442
            
            
            2.01
            %MicroCapital
                Fund LP and MicroCapital Fund Ltd(6)
            
            
            1,200,000
            
            
            1,200,000
            
            
            2,400,000
            
            
            14.12
            %All
                Officers and Directors as a group (8 persons)
            
            
            896,434
            
            
            1,498,076
            
            
            2,394,510
            
            
            13.84
            %




(1)
            Except
                as otherwise noted, the address for each of these individuals is
                c/o
                IsoRay, Inc., 350 Hills St., Suite 106, Richland, Washington
                99354.


(2)
            Percentage
                ownership is based on 15,802,394 shares of Common Stock outstanding
                on
                September 15, 2006. Shares of Common Stock subject to stock options,
                warrants or convertible debentures which are currently
                exercisable/convertible or will become exercisable/convertible within
                60
                days after September 15, 2006 are deemed outstanding for computing
                the
                percentage ownership of the person or group holding such options,
                but are
                not deemed outstanding for computing the percentage ownership of
                any other
                person or group.


(3)
            Mr.
                Boatwright’s options include 84,236 options held by an entity controlled
                by Mr. Boatwright.


(4)
            Mr.
                Babcock’s common shares include 2,695 shares owned by his
                spouse.


(5)
            Mr.
                Scallen’s address is 4701 IDS Center, Minneapolis, MN
                55302.


(6)
            MicroCapital
                Fund LP and MicroCapital Fund Ltd’s address is 1285 Avenue of the
                Americas, New York, NY 10019.




50


**Preferred
      Stock Share Ownership as of September 15, 2006**




**Name
                and Address of Beneficial Owner**
            
            **Amount
                of Preferred Shares Owned**
            
            **Options
                or Warrants Exercisable Within 60 Days of August 31,
                2006**
            
            **Total
                Preferred Shares Beneficially Owned**
            
            **Percent
                of Preferred Shares Owned****(1)**Aissata
                Sidibe(2)
            
            
            35,546
            
            
            —
            
            
            35,546
            
            
            29.01
            %Daniel
                MacKay(3)
            
            
            18,015
            
            
            —
            
            
            18,015
            
            
            14.70
            %John
                Arvid Forsman(4)
            
            
            14,218
            
            
            —
            
            
            14,218
            
            
            11.60
            %William
                and Karen Thompson Trust(5)
            
            
            14,218
            
            
            —
            
            
            14,218
            
            
            11.60
            %Jamie
                Granger(6)
            
            
            10,529
            
            
            —
            
            
            10,529
            
            
            8.59
            %James
                Hartley(7)
            
            
            9,479
            
            
            —
            
            
            9,479
            
            
            7.74
            %Hostetler
                Living Trust(8)
            
            
            9,479
            
            
            —
            
            
            9,479
            
            
            7.74
            %Forest
                Ridge Properties Ltd(9)
            
            
            6,220
            
            
            —
            
            
            6,220
            
            
            5.08
            %





(1)
            Percentage
                ownership is based on 122,543 shares of Preferred Stock outstanding
                on
                August 31, 2006. Shares of Preferred Stock subject to stock options
                or
                warrants which are currently exercisable or will become exercisable
                within
                60 days after September 15, 2006 are deemed outstanding for computing
                the
                percentage ownership of the person or group holding such options,
                but are
                not deemed outstanding for computing the percentage ownership of
                any other
                person or group.


(2)
            The
                address of Ms. Sidibe is 229 Lasiandra Ct, Richland, WA
                99352.


(3)
            The
                address of Mr. MacKay is 41 NW Sierra Drive, Camas, WA
                98607.


(4)
            The
                address of Mr. Forsman is 659 Alden Lane, Livermore, CA
                94550.


(5)
            The
                address of the William and Karen Thompson Trust is 285 Dondero Way,
                San
                Jose, CA 95119.


(6)
            The
                address of Jamie Granger is 53709 South Nine Canyon Road, Kennewick,
                WA
                99337.


(7)
            The
                address of Mr. Hartley is 1675 April Loop, Richland, WA
                99352.


(8)
            The
                address of the Hostetler Living Trust is 9257 NE 175thStreet, Bothell, WA 98011.


(9)
            The
                address of Forest Ridge Properties Ltd is 630 Montreal Street, Apt.
                1002,
                Victoria, BC V8V 4Y2.





No
      officers or directors beneficially own shares of Preferred Stock.





**ITEM
      12 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**





Through
      June 30, 2005, the Company’s former Chief Executive Officer, Thomas K. Scallen,
      advanced the Company an aggregate of approximately $44,500 to support
      operations, settle outstanding trade accounts payable and provide working
      capital. The advance was repayable upon demand and was non-interest bearing
      and
      was unsecured. Effective June 30, 2005, with the anticipation of the
      consummation of the reverse acquisition transaction with IsoRay Medical, Inc.,
      as previously discussed, these advances were forgiven and reclassified as
      additional paid-in capital in the accompanying financial statements as of that
      date.





Mr. Stephen
      Boatwright, a Company director, has been actively involved in providing various
      legal services to the Company, IsoRay Medical, Inc. and IsoRay Medical, Inc.’s
      predecessors through the law firms of Gammage and Burnham and Keller Rohrback,
      PLC. From September 2004 until January 2005, Gammage and Burnham received
      approximately $141,000 as payment for legal services performed for IsoRay
      Medical, Inc. and its predecessors. From February 2005 though June 30, 2005,
      IsoRay Medical, Inc. paid Keller Rohrback, PLC approximately $144,000 for legal
      services. During the fiscal year ended June 30, 2006, the Company paid Keller
      Rohrback, PLC approximately $390,000 for legal services. In addition, the
      Company had accrued at June 30, 2006 approximately $77,000 in legal fees to
      be
      paid. In exchange for consulting services including providing advice to IsoRay
      Medical, Inc. as to the structure of organization and compensation arrangements
      with employees and also in connection with developing various policies and
      procedures, Quatsch Ventures, LLC, an entity controlled by Mr. Boatwright,
      received options to purchase 84,236 shares of our common stock in 2004.





51




IsoRay
      Medical, Inc.’s patent rights to its Cesium-131 process were acquired from Lane
      Bray, a shareholder of the Company, and are subject to a 1% royalty on gross
      profits and certain contractual restrictions. Pursuant to the royalty agreement,
      the Company must also pay a royalty of 2% of Gross Sales, as defined, for any
      sub-assignments of the aforesaid patented process to any third parties. The
      royalty agreement will remain in force until the expiration of the patents
      on
      the assigned technology, unless earlier terminated in accordance with the terms
      of the underlying agreement. To date, there have been no product sales
      incorporating the technology and there is no royalty due pursuant to the terms
      of the agreement.





On
      January 16, 2005, in addition to certain other shareholders, the following
      officers and directors of the Company were awarded shares of common stock for
      guaranteeing a loan with the Benton Franklin Economic Development District
      (“BFEDD”) in the amount of $230,000, which was funded in December 2004, and a
      line of credit with Columbia River Bank in the amount of $395,000: Michael
      Dunlop guaranteed $15,000 of the BFEDD loan and $30,000 of the Columbia River
      Bank line of credit, for which he received 12,888 post-merger shares; Roger
      Girard guaranteed $20,000 of the BFEDD loan, for which he received 5,728
      post-merger shares; John Hrobsky guaranteed $15,000 of the Columbia River Bank
      line of credit, for which he received 4,296 post merger shares; and David
      Swanberg guaranteed $30,000 of the Columbia River Bank line of credit, for
      which
      he received 8,592 post-merger shares. During fiscal year 2006, certain original
      guarantors, including John Hrobsky, declined to continue guaranteeing the loans
      and forfeited the shares which had been granted to them. Due to this the
      following officers agreed to increase the amount of their guarantees as follows:
      Michael Dunlop guaranteed an additional $5,000 of the Columbia River Bank line
      of credit, for which he received an additional 1,432 common shares; and Roger
      Girard guaranteed an additional $105,000 of the Columbia River Bank line of
      credit, for which he received an additional 30,072 common shares.





On
      May
      27, 2005, the Company, Century Park Transitory Subsidiary, Inc., a Delaware
      corporation, Thomas Scallen and Anthony Silverman (shareholders of the Company),
      and IsoRay Medical, Inc., a Delaware corporation, entered into a Merger
      Agreement. Pursuant to the Merger Agreement, Century Park Transitory Subsidiary,
      Inc. was merged with and into IsoRay Medical, Inc. and IsoRay Medical, Inc.
      became a wholly-owned subsidiary of the Company. The Merger Agreement was
      subject to the satisfaction of certain conditions, including the granting of
      certain "piggy-back" and demand registration rights to the purchasers of certain
      convertible debentures of IsoRay Medical, Inc., Anthony Silverman and certain
      other affiliates of the Company; the agreements of the officers and directors
      of
      IsoRay Medical, Inc. to lock-up the shares of common stock of the Company they
      received in the merger for a period of one year from the closing of the merger;
      the agreements of Thomas Scallen and Anthony Silverman to escrow certain shares
      of common stock of the Company; and the receipt by IsoRay Medical, Inc. from
      Anthony Silverman or his associates of one million dollars as the purchase
      price
      of certain securities of IsoRay Medical, Inc. before the closing. These
      conditions were satisfied prior to the closing of the merger, which occurred
      on
      July 28, 2005.





The
      Board
      voted on July 28, 2005 to compensate each of the independent Directors $1,000
      per meeting for their attendance at the Board meetings. On July 28, 2005, the
      Company’s Board of Directors granted 100,000 options to purchase common stock to
      each of its three independent Directors: Thomas Lavoy, Stephen Boatwright,
      and
      Robert Kauffman. On March 31, 2006 and June 30, 2006, the Company’s Board of
      Directors granted a total of 100,000 options to purchase common stock to its
      new
      independent Directors: Albert Smith and Dwight Babcock. Directors who are also
      serving as management of the Company were not granted stock options for Director
      service, and will not be paid for attendance at Board meetings.





During
      2005, IsoRay Medical, Inc. paid or accrued $5,600 for accounting services
      performed by a company owned by a member of the Board of Directors of IsoRay
      Medical, Inc.




52


Patent
      and Know-How Royalty License Agreement





Effective
      August 1, 1998, Pacific Management Associates Corporation (PMAC) transferred
      its
      entire right, title and interest in an exclusive license agreement with Donald
      Lawrence to IsoRay, LLC (a predecessor company) in exchange for a membership
      interest. The terms of the license agreement require the payment of a royalty
      based on the Net Factory Sales Price, as defined in the agreement, of licensed
      product sales. Because the licensor’s patent application was ultimately
      abandoned, only a 1% “know-how” royalty based on Net Factory Sales Price, as
      defined, remains applicable. To date, there have been no product sales
      incorporating the licensed technology and there is no royalty due pursuant
      to
      the terms of the agreement. The Company believes that because this technology
      is
      not presently being used and believes it will not be used in the future that
      no
      royalties will be paid under this agreement.




**ITEM
      13 - EXHIBITS AND REPORTS ON FORM 8-K**




**(except
      as otherwise indicated, all exhibits were previously filed)**





**Exhibit #**
            
            **Description**2.1
            
            Merger
                Agreement dated as of May 27, 2005, by and among Century Park Pictures
                Corporation, Century Park Transitory Subsidiary, Inc., certain
                shareholders and IsoRay Medical, Inc. incorporated by reference to
                the
                Form 8-K filed on August 3, 2005.2.2
            
            Certificate
                of Merger, filed with the Delaware Secretary of State on July 28,
                2005
                incorporated by reference to the Form 8-K filed on August 3, 2005.3.1
            
            Articles
                of Incorporation and By-Laws are incorporated by reference to the
                Exhibits
                to the Company's Registration Statement of September 15,
                1983.3.2
            
            Certificate
                of Designation of Rights, Preferences and Privileges of Series A
                and B
                Convertible Preferred Stock, filed with the Minnesota Secretary of
                State
                on June 29, 2005 incorporated by reference to the Form 8-K filed
                on August
                3, 2005.3.3
            
            Restated
                and Amended Articles of Incorporation incorporated by reference to
                the
                Form 10-KSB filed on October 11, 2005.4.2
            
            Form
                of Lock-Up Agreement for Certain IsoRay Medical, Inc. Shareholders
                incorporated by reference to the Form 8-K filed on August 3,
                2005.4.3
            
            Form
                of Lock-Up Agreement for Anthony Silverman incorporated by reference
                to
                the Form 8-K filed on August 3, 2005.4.4
            
            Form
                of Registration Rights Agreement among IsoRay Medical, Inc., Century
                Park
                Pictures Corporation and the other signatories thereto incorporated
                by
                reference to the Form 8-K filed on August 3, 2005.4.5
            
            Form
                of Escrow Agreement among Century Park Pictures Corporation, IsoRay
                Medical, Inc. and Anthony Silverman incorporated by reference to
                the Form
                8-K filed on August 3, 2005.4.6
            
            Form
                of Escrow Agreement among Century Park Pictures Corporation, IsoRay
                Medical, Inc. and Thomas Scallen incorporated by reference to the
                Form 8-K
                filed on August 3, 2005.4.7
            
            Amended
                and Restated 2005 Stock Option Plan incorporated by reference to
                the Form
                S-8 filed on August 19, 2005.4.8
            
            Amended
                and Restated 2005 Employee Stock Option Plan incorporated by reference
                to
                the Form S-8 filed on August 19, 2005.4.9
            
            Form
                of Registration Right Agreement among IsoRay Medical, Inc., Meyers
                Associates, L.P. and the other signatories thereto, dated October
                15,
                2004, incorporated by reference to the Form SB-2 filed on November
                10,
                2005.4.10
            
            Form
                of Registration Rights Agreement among IsoRay, Inc., Meyers Associates,
                L.P. and the other signatories thereto, dated February 1, 2006,
                incorporated by reference to the Form SB-2/A1 filed on March 24,
                2006.4.11
            
            Form
                of IsoRay, Inc. Common Stock Purchase Warrant, incorporated by reference
                to the Form SB-2/A1 filed on March 24, 2006.




53




4.12
            
            2006
                Director Stock Option Plan, incorporated by reference to the Form
                S-8
                filed on August 18, 2006.4.13
            
            Form
                of Registration Rights Agreement among IsoRay, Inc. and the other
                signatories thereto, dated August 9, 2006, incorporated by reference
                to
                the Form 8-K filed on August 18, 2006.4.14
            
            Form
                of IsoRay, Inc. Common Stock Purchase Warrant, dated August 9, 2006,
                incorporated by reference to the Form 8-K filed on August 18,
                2006.10.2
            
            Universal
                License Agreement, dated November 26, 1997 between Donald C. Lawrence
                and
                William J. Stokes of Pacific Management Associates Corporation,
                incorporated by reference to the Form SB-2 filed on November 10,
                2005.10.3
            
            Royalty
                Agreement of Invention and Patent Application, dated July 12, 1999
                between
                Lane A. Bray and IsoRay LLC, incorporated by reference to the Form
                SB-2
                filed on November 10, 2005.10.4
            
            Tri-City
                Industrial Development Council Promissory Note, dated July 22, 2002,
                incorporated by reference to the Form SB-2/A2 filed on April 27,
                2006.10.5
            
            Section
                510(k) Clearance from the Food and Drug Administration to market
                Lawrence
                CSERION Model CS-1, dated March 28, 2003, incorporated by reference
                to the
                Form SB-2 filed on November 10, 2005.10.6
            
            Battelle
                Project No. 45836 dated June 20, 2003, incorporated by reference
                to the
                Form SB-2/A2 filed on April 27,
                2006.




10.7
            
            Applied
                Process Engineering Laboratory APEL Tenant Lease Agreement, dated
                April
                23, 2001 between Energy Northwest and IsoRay, LLC, incorporated by
                reference to the Form SB-2/A2 filed on April 27, 2006.10.8
            
            Work
                for Others Agreement No. 45658, R2, dated April 27, 2004 between
                Battelle
                Memorial Institute, Pacific Northwest Division and IsoRay Products
                LLC,
                incorporated by reference to the Form SB-2/A2 filed on April 27,
                2006.10.9
            
            Development
                Loan Agreement for $230,000, dated September 15, 2004 between
                Benton-Franklin Economic Development District and IsoRay Medical,
                Inc.,
                incorporated by reference to the Form SB-2/A2 filed on April 27,
                2006.10.10
            
            Registry
                of Radioactive Sealed Sources and Devices Safety Evaluation of Sealed
                Source, dated September 17, 2004, incorporated by reference to the
                Form
                SB-2/A2 filed on April 27, 2006.10.11
            
            CRADA
                PNNL/245, "Y-90 Process Testing for IsoRay", dated December 22, 2004
                between Pacific Northwest National Laboratory and IsoRay Medical
                Inc.,
                including Amendment No. 1, incorporated by reference to the Form
                SB-2/A2
                filed on April 27, 2006.10.12
            
            Intentionally
                Omitted10.13
            
            Amendment
                1 to Agreement 45658, dated February 23, 2005 between Battelle Memorial
                Institute Pacific Northwest Division and IsoRay Medical, Inc.,
                incorporated by reference to the Form SB-2/A2 filed on April 27,
                2006.10.14
            
            Equipment
                Lease Agreement dated April 14, 2005 between IsoRay Medical, Inc.
                and
                Nationwide Funding, LLC, incorporated by reference to the Form SB-2/A2
                filed on April 27, 2006.10.15
            
            Lease
                Agreement, Rev. 2, dated November 1, 2005 between Pacific EcoSolutions,
                Inc. and IsoRay Medical, Inc., incorporated by reference to the Form
                SB-2/A2 filed on April 27, 2006.10.16
            
            Master
                Lease Agreement Number 5209, dated May 7, 2005 between VenCore Solutions
                LLC and IsoRay Medical, Inc., incorporated by reference to the Form
                SB-2/A2 filed on April 27, 2006.10.17
            
            Contract
                #840/08624332/04031 dated August 25, 2005 between IsoRay, Inc. and
                the
                Federal State Unitary Enterprise << Institute of Nuclear Materials
                >>, Russia, incorporated by reference to the Form SB-2 filed on
                November 10, 2005.10.18
            
            State
                of Washington Radioactive Materials License dated October 6, 2005,
                incorporated by reference to the Form SB-2 filed on November 10,
                2005.




54




10.19
            
            Express
                Pricing Agreement Number 219889, dated October 5, 2005 between FedEx
                and
                IsoRay Medical, Inc., incorporated by reference to the Form 10-QSB
                filed
                on November 21, 2005.10.20
            
            Girard
                Employment Agreement, dated October 6, 2005 between Roger E. Girard
                and
                IsoRay, Inc., incorporated by reference to the Form 10-QSB filed
                on
                November 21, 2005.10.21
            
            Contract
                Modification Quality Class G, dated October 25, 2005 to Contract
                Number
                X40224 between Energy Northwest and IsoRay, Inc., incorporated by
                reference to the Form 10-QSB filed on November 21,
                2005.10.22
            
            Agreement
                dated August 9, 2005 between the Curators of the University of Missouri
                and IsoRay Medical, Inc., incorporated by reference to the Form SB-2/A2
                filed on April 27, 2006 (confidential treatment
                requested).10.23
            
            SICAV
                ONE Securities Purchase Agreement, dated December 7, 2005, by and
                between
                IsoRay, Inc. and Mercatus & Partners, Ltd., incorporated by reference
                to the Form 8-K filed on December 12, 2005.10.24
            
            SICAV
                TWO Securities Purchase Agreement, dated December 7, 2005, by and
                between
                IsoRay, Inc. and Mercatus & Partners, Ltd., incorporated by reference
                to the Form 8-K filed on December 12, 2005.10.25
            
            Economic
                Development Agreement, dated December 14, 2005, by and between IsoRay,
                Inc. and the Pocatello Development Authority, incorporated by reference
                to
                the Form 8-K filed on December 20, 2005.10.26
            
            License
                Agreement, dated February 2, 2006, by and between IsoRay Medical,
                Inc. and
                IBt SA, incorporated by reference to the Form 8-K filed on March
                24, 2006
                (confidential treatment requested).10.27
            
            Benton
                Franklin Economic Development District Loan Covenant Waiver Letter,
                dated
                as of March 31, 2005, incorporated by reference to the Form SB-2/A3
                filed
                on May 12, 2006.10.28
            
            Service
                Agreement between IsoRay, Inc. and Advanced Care Medical, Inc., dated
                March 1, 2006, incorporated by reference to the Form SB-2/A2 filed
                on
                April 27, 2006.10.29
            
            Business
                Loan Agreement between IsoRay Medical, Inc. and Columbia River Bank,
                dated
                March 1, 2006, incorporated by reference to the Form SB-2/A4 filed
                on May
                26, 2006.10.30
            
            Letter
                from HAEIFC to IsoRay Medical, Inc. dated April 26, 2006, incorporated
                by
                reference to the Form SB-2/A5 filed on June 6, 2006.10.31
            
            Loan
                Agreement, dated June 15, 2006, by and between IsoRay Medical, Inc.
                and
                the Hanford Area Economic Investment Fund Committee, incorporated
                by
                reference to the Form 8-K filed on June 21, 2006.10.32
            
            Commercial
                Security Agreement, dated June 15, 2006, by and between IsoRay Medical,
                Inc. and the Hanford Area Economic Investment Fund Committee, incorporated
                by reference to the Form 8-K filed on June 21, 2006.10.33
            
            Common
                Stock and Warrant Purchase Agreement among IsoRay, Inc. and the other
                signatories thereto, dated August 9, 2006, incorporated by reference
                to
                the Form 8-K filed on August 18, 2006.10.34
            
            Benton
                Franklin Economic Development District Loan Covenant Waiver Letter,
                dated
                September 26, 2006, filed herewith.16.1
            
            Letter
                from S.W. Hatfield, CPA to the SEC dated December 13, 2005, incorporated
                by reference to the Form 8-K filed on December 14,
                2005.21.1
            
            Subsidiaries
                of the Company, incorporated by reference to the Form 10-KSB filed
                on
                October 11, 2005.31.1
            
            Certification
                Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief
                Executive Officer, filed herewith.31.2
            
            Certification
                Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 - Chief
                Financial Officer, filed herewith.32.1
            
            Certifications
                Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed
                herewith.





55




Reports
      on Form 8-K





On
      April
      6, 2006, the Company filed a Current Report on Form 8-K announcing the expansion
      of the Board of Directors to seven members and appointing Albert Smith and
      Dwight Babcock as directors.





On
      May 2,
      2006, the Company filed a Current Report on Form 8-K/A amending its March 26,
      2006 Form 8-K filing.





On
      May 9,
      2006, the Company filed a Current Report on Form 8-K providing notice that
      certain previously filed consolidated financial statements were to be
      restated.





On
      June
      21, 2006, the Company filed a Current Report on Form 8-K announcing its entry
      into a loan agreement with the Hanford Area Economic Investment Fund Committee
      (“HAEIFC”) for a $1.4 million loan facility.





On
      August
      10, 2006, the Company filed a Current Report on Form 8-K announcing the return
      of the Mercatus shares and their cancellation.





On
      August
      18, 2006, the Company filed a Current Report on Form 8-K announcing the sale
      of
      unregistered common stock and warrants pursuant to a Common Stock and Warrant
      Purchase Agreement.





On
      September 8, 2006, the Company filed a Current Report on Form 8-K announcing
      a
      press release of the Company’s preliminary financial results for the year ended
      June 30, 2006 and anticipated first quarter of fiscal year 2007.




On
      September 11, 2006, the Company filed a Current Report on Form 8-K announcing
      the resignation of the Company’s Chief Financial Officer, the appointment of a
      new Chief Financial Officer, and the transcript from the Company’s presentation
      at the Roth Capital Conference.




**ITEM
      14 - PRINCIPAL ACCOUNTANT FEES AND SERVICES**




The
      Company paid or accrued the following fees in each of the prior two fiscal
      years
      to its principal accountant, DeCoria, Maichel & Teague, P.S., and to its
      previous principal accountant, S. W. Hatfield, CPA of Dallas, Texas:





Year
                ended June 30, 2006
            
            Nine
                months ended June 30, 2005
            
            Year
                ended September 30, 20041.Audit
                fees(1)
            
            $
            72,292
            
            $
            4,663
            
            $
            5,5122.Audit-related
                fees
            
            
            1,150
            
            
            -
            
            
            -3.Tax
                fees
            
            
            2,750
            
            
            -
            
            
            -4.All
                other fees
            
            
            -
            
            
            -
            
            
            -Totals
            
            $
            76,192
            
            $
            4,663
            
            $
            5,512




(1)
            Fees
                for the year ended June 30, 2006 were as follows: $49,125 paid to
                DeCoria,
                Maichel & Teague, P.S. and $23,167 paid to S. W. Hatfield,
                CPA.





As
      part
      of its responsibility for oversight of the independent registered public
      accountants, the Audit Committee has established a pre-approval policy for
      engaging audit and permitted non-audit services provided by our independent
      registered public accountants, DeCoria, Maichel & Teague, P.S. In accordance
      with this policy, each type of audit, audit-related, tax and other permitted
      service to be provided by the independent auditors is specifically described
      and
      each such service, together with a fee level or budgeted amount for such
      service, is pre-approved by the Audit Committee. The Audit Committee has
      delegated pre-approval authority to its Chairman to pre-approve additional
      non-audit services (provided such services are not prohibited by applicable
      law)
      up to a pre-established aggregate dollar limit. All services pre-approved by
      the
      Chairman of the Audit Committee must be presented at the next Audit Committee
      meeting for their review and ratification. All of the services provided by
      DeCoria, Maichel & Teague, P.S. described above were approved by our Audit
      Committee.





The
      Company’s principal accountant, DeCoria, Maichel & Teague P.S. did not
      engage any other persons or firms other than the principal accountant’s
      full-time, permanent employees.





56


**IsoRay,
        Inc.**
 **Index
        to Financial Statements**


**Page**Report
                  of Independent Registered Public Accounting Firm
              F-2Financial
                  Statements:Consolidated
                  Balance Sheets as of June 30, 2006 and 2005
              F-3Consolidated
                  Statements of Operations for the years ended June
                  30, 2006 and 2005
              F-4Consolidated
                  Statements of Shareholders’ Equity (Deficit) for the years ended
                  June 30, 2006 and 2005
              F-5Consolidated
                  Statements of Cash Flows for the years ended June 30, 2006
                  and 2005
              F-6Notes
                  to Consolidated Financial Statements
              F-7
  F-1




**Report
      of Independent Registered Public Accounting Firm**




Board
      of
      Directors and Shareholders


IsoRay,
      Inc.


Richland,
      Washington





We
      have
      audited the accompanying consolidated balance sheets of IsoRay, Inc. and
      Subsidiary (“the Company”) (see Note 1) as of June 30, 2006 and 2005, and the
      related consolidated statements of operations, changes in shareholders’ equity
      (deficit) and cash flows for the years then ended. These financial statements
      are the responsibility of the Company’s management. Our responsibility is to
      express an opinion on these financial statements based on our
      audits.





We
      conducted our audits in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion the financial statements referred to above present fairly, in all
      material respects, the consolidated financial position of IsoRay, Inc. and
      Subsidiary as of June 30, 2006 and 2005, and the consolidated results of their
      operations and their cash flows for the years then ended, in conformity with
      accounting principles generally accepted in the United States of
      America.





The
      accompanying financial statements have been prepared assuming that the Company
      will continue as a going concern. As discussed in Note 3 to the financial
      statements, certain conditions raise substantial doubt about the Company’s
      ability to continue as a going concern. Management's plans in regard to these
      matters are also described in Note 3. The accompanying financial statements
      do
      not include any adjustments that might result from the outcome of this
      uncertainty.





/s/
      DeCoria, Maichel & Teague, P.S.





Spokane,
      Washington


September
      26, 2006




F-2


**IsoRay,
        Inc. and Subsidiary**
 **Consolidated
        Balance Sheets**




**June
                  30,****2006**
              
              **2005****ASSETS**Current
                  assets:Cash
                  and cash equivalents
              
              $
              2,207,452
              
              $
              1,653,144Accounts
                  receivable, net of allowance for doubtful accountsof
                  $85,183 and $17,075, respectively
              
              
              596,447
              
              
              49,969Inventory
              
              
              161,381
              
              
              81,926Prepaid
                  expenses
              
              
              161,546
              
              
              181,266Total
                  current assets
              
              
              3,126,826
              
              
              1,966,305Fixed
                  assets, net of accumulated depreciation
              
              
              1,642,293
              
              
              842,323Deferred
                  financing costs, net of accumulated amortization
              
              
              274,358
              
              
              548,837Licenses,
                  net of accumulated amortization
              
              
              273,475
              
              
              18,656Other
                  assets, net of accumulated amortization
              
              
              338,987
              
              
              226,263Total
                  assets
              
              $
              5,655,939
              
              $
              3,602,384**LIABILITIES
                  AND SHAREHOLDERS' EQUITY (DEFICIT)**Current
                  liabilities:Accounts
                  payable and accrued expenses
              
              $
              584,296
              
              $
              695,588Accrued
                  payroll and related taxes
              
              
              614,645
              
              
              157,924Accrued
                  interest payable
              
              
              11,986
              
              
              41,325Notes
                  payable, due within one year
              
              
              51,351
              
              
              43,116Capital
                  lease obligations, due within one year
              
              
              183,554
              
              
              9,604Convertible
                  debentures payable, due within one year
              
              
              455,000
              
              
              -Total
                  current liabilities
              
              
              1,900,832
              
              
              947,557Notes
                  payable, due after one year
              
              
              581,557
              
              
              562,224Capital
                  lease obligations, due after one year
              
              
              220,415
              
              
              19,584Convertible
                  debentures payable, due after one year
              
              
              -
              
              
              3,587,875Asset
                  retirement obligation
              
              
              67,425
              
              
              -Total
                  liabilities
              
              
              2,770,229
              
              
              5,117,240Shareholders'
                  equity (deficit):Preferred
                  stock, $.001 par value; 6,000,000 shares authorized:Series
                  A: 1,000,000 shares allocated; no shares issued and outstanding
              
              
              -
              
              
              -Series
                  B: 5,000,000 shares allocated; 144,759 and 1,338,167 shares issued
                  andoutstanding
              
              
              145
              
              
              1,338Common
                  stock, $.001 par value; 194,000,000 and 100,000,000 shares authorized;15,157,901
                  and 6,163,623 shares issued and outstanding
              
              
              15,158
              
              
              6,164Subscriptions
                  receivable
              
              
              (6,122,007
              )
              
              -Additional
                  paid-in capital
              
              
              22,538,675
              
              
              3,805,773Accumulated
                  deficit
              
              
              (13,546,261
              )
              
              (5,328,131
              )Total
                  shareholders' equity (deficit)
              
              
              2,885,710
              
              
              (1,514,856
              )Total
                  liabilities and shareholders' equity (deficit)
              
              $
              5,655,939
              
              $
              3,602,384


The
        accompanying notes are an integral part of these financial
        statements.


F-3







**IsoRay,
                  Inc. and Subsidiary****Consolidated
                  Statements of Operations**




**Year
                  ended June 30,****2006**
              
              **2005**Product
                  sales
              
              $
              1,994,306
              
              $
              201,731Cost
                  of product sales
              
              
              3,815,122
              
              
              1,474,251Gross
                  loss
              
              
              (1,820,816
              )
              
              (1,272,520
              )Operating
                  expenses:Research
                  and development
              
              
              450,425
              
              
              137,532Sales
                  and marketing expenses
              
              
              1,420,500
              
              
              701,822General
                  and administrative expenses
              
              
              3,503,522
              
              
              1,871,325Total
                  operating expenses
              
              
              5,374,447
              
              
              2,710,679Operating
                  loss
              
              
              (7,195,263
              )
              
              (3,983,199
              )Non-operating
                  income (expense):Interest
                  income
              
              
              51,744
              
              
              2,394Financing
                  expense
              
              
              (689,100
              )
              
              (167,493
              )Loss
                  on disposal of fixed assets
              
              
              -
              
              
              (120,890
              )Debt
                  conversion expense (Note 11)
              
              
              (385,511
              )
              
              -Non-operating
                  income (expense), net
              
              
              (1,022,867
              )
              
              (285,989
              )Net
                  loss
              
              $
              (8,218,130
              )
              $
              (4,269,188
              )Basic
                  loss per share
              
              $
              (0.68
              )
              $
              (0.78
              )Shares
                  used in computing net loss per share:Basic
              
              
              12,051,964
              
              
              5,470,046




The
        accompanying notes are an integral part of these financial
        statements.




F-4







**IsoRay,
        Inc. and Subsidiary**
 **Consolidated
        Statement of Changes in Shareholders' Equity (Deficit)**


**IsoRay,
                  Inc. (MN****)
                  (1)**
              
              
              
              
              
              **IsoRay
                  Medical, Inc.****Series
                  B Preferred Stock**
              
              **Common
                  Stock**
              
              **IsoRay,
                  Inc. (WA) Common Stock****(2)**
              
              **Series
                  B Preferred Stock**
              
              **Common
                  Stock**
              
              **Subscriptions**
              
              **Additional
                  Paid-in**
              
              **Accumulated****Shares**
              
              **Amount**
              
              **Shares**
              
              **Amount**
              
              **Shares**
              
              **Amount**
              
              **Shares**
              
              **Amount**
              
              **Shares**
              
              **Amount**
              
              **Receivable**
              
              **Capital**
              
              **Deficit**
              
              **Total**Balances
                  at June 30, 2004
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -
              
              
              2,767,700
              
              $
              2,768
              
              
              -
              
              $
              -
              
              
              8,424
              
              $
              8
              
              $
              -
              
              $
              1,369,910
              
              $
              (1,058,943
              )
              $
              313,743Issuance
                  of IsoRay, Inc. (WA) common shares pursuant to exercise of options
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              71,580
              
              
              71
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              71,509
              
              
              
              
              
              71,580Issuance
                  of IsoRay, Inc. (WA) common shares as compensation
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              57,025
              
              
              57
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              56,968
              
              
              
              
              
              57,025Issuance
                  of IsoRay Products LLC member shares for cash, net of offering
                  costs
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              303,743
              
              
              
              
              
              303,743Merger
                  of IsoRay, Inc (WA) and IsoRay Products LLC into IsoRay Medical,
                  Inc.
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (2,896,305
              )
              
              (2,896
              )
              
              1,249,832
              
              
              1,249
              
              
              5,195,205
              
              
              5,196
              
              
              
              
              
              (3,549
              )
              
              
              
              
              -Reversal
                  of dividends accrued by IsoRay Products LLC
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              91,765
              
              
              
              
              
              91,765Issuance
                  of IsoRay Medical, Inc. common shares for cash pursuant to privateplacement,
                  net of offering costs
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              644,828
              
              
              645
              
              
              
              
              
              1,355,933
              
              
              
              
              
              1,356,578Issuance
                  of IsoRay Medical, Inc. common shares pursuant to exercise of warrantsgranted
                  in connection with private placement
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              109,296
              
              
              109
              
              
              
              
              
              64,766
              
              
              
              
              
              64,875Issuance
                  of IsoRay Medical, Inc. common shares as inducement for guarantee
                  of debt
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              177,856
              
              
              178
              
              
              
              
              
              348,203
              
              
              
              
              
              348,381Issuance
                  of IsoRay Medical, Inc. common shares as partial payment for laserwelding
                  stations
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              25,526
              
              
              26
              
              
              
              
              
              49,974
              
              
              
              
              
              50,000Issuance
                  of Series B preferred shares pursuant to exercise of warrants
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              90,823
              
              
              91
              
              
              
              
              
              
              
              
              
              
              
              96,651
              
              
              
              
              
              96,742Exchange
                  of Series B preferred shares for IsoRay Medical, Inc. common shares
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (2,488
              )
              
              (2
              )
              
              2,488
              
              
              2
              
              
              
              
              
              -
              
              
              
              
              
              -Payments
                  to common shareholders in lieu of issuing fractional shares
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (100
              )
              
              
              
              
              (100
              )Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (4,269,188
              )
              
              (4,269,188
              )Balances
                  at June 30, 2005
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              1,338,167
              
              
              1,338
              
              
              6,163,623
              
              
              6,164
              
              
              -
              
              
              3,805,773
              
              
              (5,328,131
              )
              
              (1,514,856
              )Merger
                  of IsoRay, Inc. (formerly Century Park Pictures Corporation) andIsoRay
                  Medical, Inc., net of fractional shares paid in cash (see Note
                  1)
              
              
              1,338,132
              
              
              1,338
              
              
              6,163,518
              
              
              6,164
              
              
              
              
              
              
              
              
              (1,338,167
              )
              
              (1,338
              )
              
              (6,163,623
              )
              
              (6,164
              )
              
              
              
              
              
              
              
              
              
              
              -Common
                  stock held by shareholders of Century Park Picture Corporationafter
                  the reverse acquisition
              
              
              
              
              
              
              
              
              2,498,534
              
              
              2,499
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              8,733
              
              
              
              
              
              11,232Issuance
                  of common shares as payment for merger consulting services
              
              
              
              
              
              
              
              
              168,472
              
              
              169
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              329,831
              
              
              
              
              
              330,000Payments
                  to shareholders in lieu of issuing fractional shares
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (734
              )
              
              
              
              
              (734
              )Issuance
                  of preferred stock pursuant to exercise of warrants
              
              
              8,708
              
              
              8
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              6,977
              
              
              
              
              
              6,985Issuance
                  of preferred stock pursuant to exercise of warrants paid by surrendinga
                  partial note payable
              
              
              44,788
              
              
              45
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              48,268
              
              
              
              
              
              48,313Issuance
                  of common stock pursuant to exercise of warrants
              
              
              
              
              
              
              
              
              84,147
              
              
              84
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              49,866
              
              
              
              
              
              49,950Issuance
                  of common stock pursuant to exercise of options
              
              
              
              
              
              
              
              
              101,284
              
              
              101
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              119,476
              
              
              
              
              
              119,577Conversion
                  of preferred stock to common stock
              
              
              (1,246,869
              )
              
              (1,246
              )
              
              1,246,869
              
              
              1,246
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Exchange
                  of convertible debentures payable to common stock
              
              
              
              
              
              
              
              
              911,271
              
              
              911
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              3,681,964
              
              
              
              
              
              3,682,875Issuance
                  of warrants pursuant to short-term inducement to convert debentures
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              385,511
              
              
              
              
              
              385,511Issuance
                  of warrants as inducement for note payable from shareholder (see
                  Note 9)
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              60,000
              
              
              
              
              
              60,000Issuance
                  of common stock pursuant to the October 2005 privateplacement,
                  net of offering costs
              
              
              
              
              
              
              
              
              1,500,000
              
              
              1,500
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              5,406,626
              
              
              
              
              
              5,408,126Issuance
                  of common stock pursuant to the February 2006 privateplacement,
                  net of offering costs
              
              
              
              
              
              
              
              
              268,889
              
              
              269
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,107,955
              
              
              
              
              
              1,108,224Issuance
                  of common stock to Mercatus subject to a subscriptionreceivable
                  agreement
              
              
              
              
              
              
              
              
              1,748,146
              
              
              1,748
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (6,122,007
              )
              
              6,120,259
              
              
              
              
              
              -Issuance
                  of common stock for payment of invoices
              
              
              
              
              
              
              
              
              39,007
              
              
              39
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              184,996
              
              
              
              
              
              185,035Issuance
                  of common stock pursuant to the June 2006 warrantexercise
                  solicitation, net of offering costs
              
              
              
              
              
              
              
              
              427,764
              
              
              428
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,223,174
              
              
              
              
              
              1,223,602Net
                  loss
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              (8,218,130
              )
              
              (8,218,130
              )Balances
                  at June 30, 2006
              
              
              144,759
              
              $
              145
              
              
              15,157,901
              
              $
              15,158
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -
              
              $
              (6,122,007
              )
              $
              22,538,675
              
              $
              (13,546,261
              )
              $
              2,885,710
  1.
          IsoRay, Inc (MN) is the current registrant (formerly Century Park Pictures
          Corporation) and a Minnesota corporation.
 2.
          IsoRay, Inc. (WA) is a former Washington corporation which was merged into
          IsoRay Medical, Inc. in fiscal year 2005.
 The
          accompanying notes are an integral part of these financial
          statements.




F-5


**IsoRay,
                  Inc. and Subsidiary****Consolidated
                  Statements of Cash Flows**




**Year
                  ended June 30,****2006**
              
              **2005****CASH
                  FLOWS FROM OPERATING ACTIVITIES:**Net
                  loss
              
              $
              (8,218,130
              )
              $
              (4,269,188
              )Adjustments
                  to reconcile net loss to net cash used by operating activities:Depreciation
                  and amortization of fixed assets
              
              
              271,060
              
              
              140,099Amortization
                  of deferred financing costs and other assets
              
              
              384,266
              
              
              82,358Accretion
                  of asset retirement obligation
              
              
              4,385
              
              
              -Loss
                  on disposal of fixed assets
              
              
              -
              
              
              120,890Merger
                  consulting fees paid by issuance of common stock
              
              
              330,000
              
              
              -Consulting
                  and repair fees paid by issuance of common stock
              
              
              39,750
              
              
              57,025Rent
                  expense paid by issuance of common stock
              
              
              90,026
              
              
              -Debt
                  conversion expense (Note 11)
              
              
              385,511
              
              
              -Changes
                  in operating assets and liabilities:Accounts
                  receivable, net
              
              
              (546,478
              )
              
              (49,969
              )Inventory
              
              
              (79,455
              )
              
              (62,200
              )Prepaid
                  expenses
              
              
              41,252
              
              
              (104,133
              )Accounts
                  payable and accrued expenses
              
              
              (132,646
              )
              
              566,567Accrued
                  payroll and related taxes
              
              
              456,721
              
              
              99,914Accrued
                  interest payable
              
              
              (29,339
              )
              
              33,090Net
                  cash used by operating activities
              
              
              (7,003,077
              )
              
              (3,385,547
              )**CASH
                  FLOWS FROM INVESTING ACTIVITIES:**Purchases
                  of fixed assets
              
              
              (474,795
              )
              
              (724,029
              )Additions
                  to licenses and other assets
              
              
              (395,201
              )
              
              (431,438
              )Cash
                  acquired in reverse acquisition (Note 1)
              
              
              32,587
              
              
              -Net
                  cash used by investing activities
              
              
              (837,409
              )
              
              (1,155,467
              )**CASH
                  FLOWS FROM FINANCING ACTIVITIES:**Proceeds
                  from issuance of notes payable, net of financing costs
              
              
              646,542
              
              
              315,000Proceeds
                  from sales of convertible debentures payable
              
              
              550,000
              
              
              3,587,875Principal
                  payments on notes payable
              
              
              (592,790
              )
              
              (23,653
              )Principal
                  payments on capital lease obligations
              
              
              (124,688
              )
              
              (2,914
              )Proceeds
                  from cash sales of common shares pursuant to private placement,
                  net of
                  offering costs
              
              
              6,516,350
              
              
              1,847,511Proceeds
                  from cash sales of preferred stock, pursuant to exercise of warrants
              
              
              6,985
              
              
              -Proceeds
                  from cash sales of common stock, pursuant to exercise of warrants
              
              
              49,950
              
              
              -Proceeds
                  from cash sales of common stock, pursuant to exercise of options
              
              
              119,577
              
              
              -Proceeds
                  from cash sales of common stock, pursuant to June 2006 warrant
                  exercises
              
              
              1,223,602
              
              
              -Payments
                  to common shareholders in lieu of issuing fractional shares
              
              
              (734
              )
              
              (100
              )Net
                  cash provided by financing activities
              
              
              8,394,794
              
              
              5,723,719Net
                  increase in cash and cash equivalents
              
              
              554,308
              
              
              1,182,705Cash
                  and cash equivalents, beginning of period
              
              
              1,653,144
              
              
              470,439**CASH
                  AND CASH EQUIVALENTS, END OF PERIOD**
              
              $
              2,207,452
              
              $
              1,653,144Supplemental
                  disclosures of cash flow information:Cash
                  paid for interest
              
              $
              361,832
              
              $
              57,657Non-cash
                  investing and financing activities:Exchange
                  of convertible debentures payable for shares of common stock
              
              $
              3,682,875
              
              $
              -Fixed
                  assets acquired by capital lease obligations
              
              
              507,947
              
              
              32,102Increase
                  in PP&E related to asset retirement obligation
              
              
              63,040Issuance
                  of common shares as partial payment for production equipment
              
              
              25,248
              
              
              50,000Issuance
                  of common shares as partial payment of notes payable
              
              
              48,313
              
              
              -Liabilities
                  acquired in acquisition
              
              
              21,355
              
              
              -Prepaid
                  rent paid by issuance of common stock
              
              
              120,036
              
              
              -Issuance
                  of warrants as an inducement for a note payable
              
              
              60,000
              
              
              -Issuance
                  of preferred shares for debt reduction
              
              
              -
              
              
              46,007Issuance
                  of common shares as compensation for guarantee of debt
              
              
              -
              
              
              348,381Reversal
                  of dividends payable to IsoRay Products LLC members
              
              
              -
              
              
              (91,765
              )




The
        accompanying notes are an integral part of these financial
        statements.




F-6




**IsoRay,
      Inc.**


**Notes
      to Consolidated Financial Statements**


**For
      the years ended June 30, 2006 and 2005**





**1.** **Organization**





Historical
      Organization





Century
      Park Pictures Corporation (“Century”) was organized under Minnesota law in 1983.
      Century is a public company subject to the periodic reporting requirements
      of
      the Securities Exchange Act of 1934.




Century
      had no operations since its fiscal year ended September 30, 1999 through June
      30, 2005.





Merger
      Transaction





On
      May
      27, 2005, IsoRay Medical, Inc. (“Medical”) entered into a merger agreement with
      Century to merge with Century’s newly-formed, wholly-owned subsidiary.





On
      July
      28, 2005, the merger transaction closed. As a result of the merger, Medical
      became a wholly-owned subsidiary of Century, which concurrently changed its
      name
      to IsoRay, Inc. (“IsoRay” or “the Company”).





IsoRay
      issued shares of its common and preferred stock to the holders of common and
      preferred stock of Medical at a rate of 0.842362 share of IsoRay’s stock for
      each share of Medical’s stock. Options and warrants to purchase common and
      preferred stock of Medical were also converted at the same rate into options
      and
      warrants to purchase common and preferred stock of IsoRay, Inc. On a
      fully-diluted basis, Medical’s shareholders owned approximately 82% of IsoRay’s
      outstanding securities.





Management
      believes the transaction was structured to qualify as a non-taxable
      reorganization under Section 368(a)(1)(A) of the Internal Revenue Code of 1986,
      as amended.





Financial
      Presentation





Medical,
      a Delaware corporation, was incorporated effective June 15, 2004 to develop,
      manufacture and sell isotope-based medical products and devices for the
      treatment of cancer and other diseases. Medical is headquartered in Richland,
      Washington.





Medical
      was formed for the purpose of combining the operations of IsoRay, Inc. (a former
      Washington corporation) (“IsoRay (WA)”) and its subsidiary, IsoRay Products LLC,
      two companies that shared common ownership and management with Medical.
      Medical’s management initiated a merger transaction effective October 1, 2004,
      in order to accomplish the combining of operations.





Statement
      of Financial Accounting Standards (SFAS) No. 141, *Business
      Combinations* ,
      requires that following a merger the accounting acquirer’s financial statements
      should be used for historical comparisons. Although the legal acquirer was
      Century, for accounting purposes Medical was the acquirer and as such Medical’s
      historical financial statements are shown for comparative purposes. Also for
      accounting purposes, the merger was accounted for as though it happened on
      July
      1, 2005.





As
      part
      of the reverse merger, Medical acquired cash of $32,587 and accounts payable
      of
      $21,355.





F-7


**2.** **Summary
        of Significant Accounting Policies**





Consolidation





The
      accompanying consolidated financial statements include the accounts of the
      Company and its wholly-owned subsidiary (collectively the “Company”). All
      significant intercompany accounts and transactions have been
      eliminated.





Basis
      of Presentation





During
      the fourth quarter of fiscal year 2005, Medical’s management determined that
      Medical had emerged from the development stage, inasmuch as its planned
      principal operations had commenced. Prior to that time, Medical’s activities had
      consisted primarily of conducting research and development and soliciting equity
      and debt financing. Accordingly, the Company’s financial statements are no
      longer presented as those of a development stage enterprise as they were in
      prior periods, as prescribed by Statement of Financial Accounting Standards
      (SFAS) No. 7, *Accounting
      and Reporting by Development Stage Enterprises* .





Cash
      Equivalents





The
      Company considers all highly liquid investments with maturities of three months
      or less when purchased to be cash equivalents.





Accounts
      Receivable





Accounts
      receivable are stated at the amount that management of the Company expects
      to
      collect from outstanding balances. Management provides for probable
      uncollectible amounts through an allowance for doubtful accounts. Additions
      to
      the allowance for doubtful accounts are based on management’s judgment,
      considering historical write-offs, collections and current credit conditions.
      Balances which remain outstanding after management has used reasonable
      collection efforts are written off through a charge to the allowance for
      doubtful accounts and a credit to the applicable accounts receivable. Payments
      received subsequent to the time that an account is written off are considered
      bad debt recoveries.





Inventory





Inventory
      is reported at the lower of cost, determined using the weighted average method,
      or net realizable value.





Fixed
      Assets





Fixed
      assets are carried at the lower of cost or net realizable value. Production
      equipment with a cost of $2,500 or greater, and other fixed assets with a cost
      of $1,000 or greater are capitalized. Major betterments that extend the useful
      lives of assets are also capitalized. Normal maintenance and repairs are charged
      to expense as incurred. When assets are sold or otherwise disposed of, the
      cost
      and accumulated depreciation are removed from the accounts and any resulting
      gain or loss is recognized in operations.





Depreciation
      is computed using the straight-line method over the following estimated useful
      lives:




Production
                equipment
            7 yearsOffice
                equipment
            5 yearsFurniture
                and fixtures
            5
              years




Leasehold
      improvements and capital lease assets are amortized over the shorter of the
      life
      of the lease or the estimated life of the asset.





F-8




The
      Company has adopted the provisions of SFAS No. 144, *Accounting
      for the Impairment or Disposal of Long-Lived Assets* .
      The
      provisions of SFAS No. 144 require that an impairment loss be recognized when
      the estimated future cash flows (undiscounted and without interest) expected
      to
      result from the use of an asset are less than the carrying amount of the asset.
      Measurement of an impairment loss is based on the estimated fair value of the
      asset if the asset is expected to be held and used.





Management
      of the Company periodically reviews the net carrying value of all of its
      equipment on an asset by asset basis. These reviews consider the net realizable
      value of each asset, as measured in accordance with the preceding paragraph,
      to
      determine whether an impairment in value has occurred, and the need for any
      asset impairment write-down.





Although
      management has made its best estimate of the factors that affect the carrying
      value based on current conditions, it is reasonably possible that changes could
      occur which could adversely affect management's estimate of net cash flows
      expected to be generated from its assets, and necessitate asset impairment
      write-downs.





Deferred
      Financing Costs





Financing
      costs related to the acquisition of debt are deferred and amortized over the
      term of the related debt using the effective interest method.  Deferred
      financing costs include the fair value of shares issued to certain shareholders
      for their guarantee of certain Company debt (see Notes 8 and 9). Amortization
      of
      deferred financing costs, totaling $296,608 and $76,746 for the years ended
      June
      30, 2006 and 2005, respectively, is included in financing expense on the
      statements of operations.





Licenses





Amortization
      of licenses is computed using the straight-line method over the estimated
      economic useful lives of the assets. In fiscal year 2006, the Company entered
      into an agreement with IBt, SA, a Belgian company (“IBt”) to use IBt’s
      proprietary “Ink Jet” production process and paid to IBt $275,000. The IBt
      license is being amortized over the 15 year term of the license. Amortization
      of
      licenses was $20,530 and $2,674 for the years ended June 30, 2006 and 2005,
      respectively.





The
      Company periodically reviews the carrying values of licenses in accordance
      with
      SFAS No. 144 and any impairments are recognized when the expected future
      operating cash flows to be derived from such assets are less than their carrying
      value.





Based
      on
      the licenses recorded at June 30, 2006, and assuming no subsequent impairment
      of
      the underlying assets, the annual amortization expense for each fiscal year
      ending June 30th, is expected to be as follows: $20,224 for 2007, $20,224 for
      2008, $20,224 for 2009, $18,600 for 2010, and $18,333 for 2011.





Other
      Assets





Other
      assets, which include deferred charges and patents, are stated at cost, less
      accumulated amortization. Amortization of patents is computed using the
      straight-line method over the estimated economic useful lives of the assets.
      The
      Company periodically reviews the carrying values of patents in accordance with
      SFAS No. 144 and any impairments are recognized when the expected future
      operating cash flows to be derived from such assets are less than their carrying
      value.





Based
      on
      the patents and other intangible assets recorded in other assets at June 30,
      2006, and assuming no subsequent impairment of the underlying assets, the annual
      amortization expense for each fiscal year ending June 30th, is expected to
      be as
      follows: $10,790 for 2007, $4,826 for 2008, $1,843 for 2009, $1,843 for 2010,
      and $1,843 for 2011.




F-9




Asset
      Retirement Obligation





SFAS
      No.
      143, *Asset
      Retirement Obligations* ,
      establishes standards for the recognition, measurement and disclosure of legal
      obligations associated with the costs to retire long-lived assets. Accordingly,
      under SFAS No. 143, the fair value of the future retirement costs of the
      Company’s leased assets are recorded as a liability on a discounted basis when
      it is incurred and an equivalent amount is capitalized to property and
      equipment. The initial recorded obligation, which has been discounted using
      the
      Company’s credit-adjusted risk free-rate, will be reviewed periodically to
      reflect the passage of time and changes in the estimated future costs underlying
      the obligation. The Company amortizes the initial amount capitalized to property
      and equipment and recognizes accretion expense in connection with the discounted
      liability over the estimated remaining useful life of the leased
      assets.





During
      the years ended June 30, 2006 and 2005, the asset retirement obligation changed
      as follows:




2006Beginning
                balance
            
            
            
            
            $
            -New
                obligations
            
            
            
            
            
            63,040Accretion
                of discount
            
            
            
            
            
            4,385Ending
                balance
            
            
            
            
            $
            67,425




Financial
      Instruments





The
      Company discloses the fair value of financial instruments, both assets and
      liabilities, recognized and not recognized in the balance sheet, for which
      it is
      practicable to estimate the fair value. The fair value of a financial instrument
      is the amount at which the instrument could be exchanged in a current
      transaction between willing parties, other than a forced liquidation
      sale.





The
      carrying amounts of financial instruments, including cash and cash equivalents;
      accounts receivable; accounts payable; notes payable; capital lease obligations;
      and convertible debentures payable, approximated their fair values at June
      30,
      2006 and 2005.





Revenue
      Recognition





The
      Company applies the provisions of SEC Staff Accounting Bulletin (“SAB”)
      No. 104, *Revenue
      Recognition* .
      SAB
      No. 104, which supersedes SAB No. 101, *Revenue
      Recognition in Financial Statements* ,
      provides guidance on the recognition, presentation and disclosure of revenue
      in
      financial statements. SAB No. 104 outlines the basic criteria that must be
      met to recognize revenue and provides guidance for the disclosure of revenue
      recognition policies. The Company recognizes revenue related to product sales
      when (i) persuasive evidence of an arrangement exists, (ii) shipment
      has occurred, (iii) the fee is fixed or determinable, and
      (iv) collectibility is reasonably assured.




Revenue
      for the fiscal years ended June 30, 2006 and 2005 was derived solely from sales
      of the 131 Cs
      brachytherapy seed, which is used in the treatment of cancer. The Company
      recognizes revenue once an order has been received and shipped to the customer.
      Prepayments, if any, received from customers prior to the time that products
      are
      shipped are recorded as deferred revenue. In these cases, when the related
      products are shipped, the amount recorded as deferred revenue is recognized
      as
      revenue. The Company accrues for sales returns and other allowances at the
      time
      of shipment.





Stock-Based
      Compensation





SFAS
      No.
      123, *Accounting
      for Stock-Based Compensation* ,
      as
      amended by SFAS No. 148, requires companies to recognize stock-based expense
      based on the estimated fair value of employee stock options. Alternatively,
      SFAS
      No. 123 allows companies to retain the current approach set forth in Accounting
      Principles Board Opinion No. 25, *Accounting
      for Stock Issued to Employees* (APB
      25),
      provided that expanded footnote disclosure is presented. The Company has not
      adopted the fair value method of accounting for stock-based compensation under
      SFAS No. 123, but provides the pro forma disclosure required when appropriate
      (see Note 12).





F-10




Research
      and Development Costs





Research
      and development costs, including salaries, research materials, administrative
      expenses and contractor fees, are charged to operations as incurred. The cost
      of
      equipment used in research and development activities which has alternative
      uses
      is capitalized as part of fixed assets and not treated as an expense in the
      period acquired. Depreciation of capitalized equipment used to perform research
      and development is classified as research and development expense in the year
      computed.





Advertising
      and Marketing Costs





Advertising
      and marketing costs are expensed as incurred except for the cost of tradeshows
      which are deferred until the tradeshow occurs.





Shipping
      and Handling Costs





Shipping
      and handling costs are expensed as incurred and included in cost of product
      sales.





Legal
      Contingencies





In
      the
      ordinary course of business, the Company is involved in legal proceedings
      involving contractual and employment relationships, product liability claims,
      patent rights, and a variety of other matters. The Company records contingent
      liabilities resulting from asserted and unasserted claims against it, when
      it is
      probable that a liability has been incurred and the amount of the loss is
      reasonably estimable. The Company discloses contingent liabilities when there
      is
      a reasonable possibility that the ultimate loss will exceed the recorded
      liability. Estimating probable losses requires analysis of multiple factors,
      in
      some cases including judgments about the potential actions of third-party
      claimants and courts. Therefore, actual losses in any future period are
      inherently uncertain. Currently, the Company does not believe any probable
      legal
      proceedings or claims will have a material impact on its financial position
      or
      results of operations. However, if actual or estimated probable future losses
      exceed the Company’s recorded liability for such claims, it would record
      additional charges as other expense during the period in which the actual loss
      or change in estimate occurred.





Income
      Taxes





Income
      taxes are accounted for under the liability method. Under this method, the
      Company provides deferred income taxes for temporary differences that will
      result in taxable or deductible amounts in future years based on the reporting
      of certain costs in different periods for financial statement and income tax
      purposes. This method also requires the recognition of future tax benefits
      such
      as net operating loss carryforwards, to the extent that realization of such
      benefits is more likely than not. Deferred tax assets and liabilities are
      measured using enacted tax rates expected to apply to taxable income in the
      years in which those temporary differences are expected to be recovered or
      settled. The effect on deferred tax assets and liabilities of a change in tax
      rates is recognized in operations in the period that includes the enactment
      of
      the change.





Income
      (Loss) Per Common Share





The
      Company accounts for its income (loss) per common share according to SFAS No.
      128, *Earnings
      Per Share* .
      Under
      the provisions of SFAS No. 128, primary and fully diluted earnings per share
      are
      replaced with basic and diluted earnings per share. Basic earnings per share
      is
      calculated by dividing net income (loss) available to common shareholders by
      the
      weighted average number of common shares outstanding, and does not include
      the
      impact of any potentially dilutive common stock equivalents. Common stock
      equivalents, including warrants to purchase the Company's common stock and
      common stock issuable upon the conversion of notes payable, are excluded from
      the calculations when their effect is antidilutive. Basic weighted average
      shares outstanding for the year ended June 30, 2005 have been adjusted to
      reflect the exchange ratio contained in the merger transaction dated July 28,
      2005 (see Note 1). At June 30, 2006 and 2005, the calculation of diluted
      weighted average shares does not include preferred stock, options, or warrants
      that are potentially convertible into common stock as those would be
      antidilutive due to the Company’s net loss position.





F-11




Securities
      that could be dilutive in the future as of June 30, 2006 and 2005 are as
      follows:


2006
              
              2005Preferred
                  stock
              
              
              144,759
              
              
              1,338,167Preferred
                  stock warrants
              
              
              179,512
              
              
              233,008Common
                  stock warrants
              
              
              2,502,769
              
              
              136,158Common
                  stock options
              
              
              3,129,692
              
              
              2,237,802Convertible
                debentures
              
              
              109,639
              
              
              864,548Total
                  potential dilutive securities
              
              
              6,066,371
              
              
              4,809,683





Use
      of
      Estimates





The
      preparation of financial statements in accordance with accounting principles
      generally accepted in the United States of America requires management of the
      Company to make estimates and assumptions that affect the amounts reported
      in
      the financial statements and accompanying notes. Accordingly, actual results
      could differ from those estimates and affect the amounts reported in the
      financial statements.





Reclassification
      Entries





Certain
      reclassifications, primarily the separate disclosure of deferred financing
      costs
      and licenses, have been made to the 2005 financial statements to conform to
      the
      presentation in the 2006 financial statements.





**3.**  **Risks
      and Uncertainties**





The
      Company’s financial statements have been prepared on a going concern basis,
      which contemplates the realization of assets and settlement of liabilities
      and
      commitments in the normal course of business. However, our large operating
      losses and accumulated deficit, among other things, raise substantial doubt
      about our ability to continue as a going concern. Management plans to raise
      additional financing (including the sale of additional equity or borrowings)
      and
      grow the revenues of our core product while continually analyzing other market
      opportunities. However, no assurance can be given that such financing will
      be
      completed on terms acceptable to the Company or that the Company will be able
      to
      meet its revenue targets. If the Company is unable to obtain additional
      financing and grow revenues, we may have to curtail our business or cease
      operations. The financial statements do not include any adjustments relating
      to
      the recoverability of assets and classification of liabilities that might be
      necessary should the Company be unable to continue as a going
      concern.





**4.**  **Inventory**





Inventory
      consists of the following at June 30, 2006 and 2005:




2006
              
              2005Raw
                  materials
              
              $
              61,531
              
              $
              27,659Work
                  in process
              
              
              67,906
              
              
              54,267Finished
                  goods
              
              
              31,944
              
              
              -$
              161,381
              
              $
              81,926





F-12




The
      cost
      of materials and production costs contained in inventory that are not useable
      due to the passage of time, and resulting loss of bio-effectiveness, are written
      off to cost of product sales at the time it is determined that the product
      is
      not useable. It is not possible to determine what portion of cost of product
      sales is represented by “spoilage.”





**5.**  **Prepaid
      Expenses**





Prepaid
      expenses consist of the following at June 30, 2006 and 2005:


2006
              
              2005Prepaid
                  contract work
              
              $
              7,913
              
              $
              65,328Prepaid
                  insurance
              
              
              21,340
              
              
              15,853Prepaid
                  rent
              
              
              30,009
              
              
              -Other
                  prepaid expenses
              
              
              102,284
              
              
              100,085$
              161,546
              
              $
              181,266


**6.**  **Fixed
      Assets**





Fixed
      assets consist of the following at June 30, 2006 and 2005:


2006
              
              2005Production
                  equipment
              
              $
              590,908
              
              $
              399,448Office
                  equipment
              
              
              70,060
              
              
              31,028Furniture
                  and fixtures
              
              
              100,653
              
              
              7,736Leasehold
                  improvements
              
              
              652,404
              
              
              138,692Capital
                  lease assets (a)
              
              
              599,738
              
              
              34,049Construction
                  in progress
              
              
              34,254
              
              
              366,0342,048,017
              
              
              976,987Less
                  accumulated depreciation
              
              
              (405,724
              )
              
              (134,664
              )$
              1,642,293
              
              $
              842,323




(a)  June
      30,
      2006 balance includes asset retirement addition of $63,040.





Depreciation
      and amortization expense related to fixed assets totaled $271,060 and $140,099
      for 2006 and 2005, respectively. Accumulated amortization of capital lease
      assets totaled $55,644 at June 30, 2006.





**7.**  **Other
      Assets**





Other
      assets, net of accumulated amortization, consist of the following at June 30,
      2006 and 2005:


2006
              
              2005Deferred
                  charges
              
              $
              318,885
              
              $
              204,649Patents
                  and trademarks, net of accumulated amortization of $13,831 and
                  $12,318
              
              
              20,102
              
              
              21,614$
              338,987
              
              $
              226,263




Deferred
      charges consist of prepaid legal fees for patents which have not yet been
      obtained, and prepayments and deposits on fixed assets and contracts.
      Amortization of patents and trademarks was $1,513 and $2,938 for the years
      ended
      June 30, 2006 and 2005, respectively.





F-13




**8.**  **Bank
      Line of Credit**





The
      Company has a $375,000 revolving line of credit with Columbia River Bank that
      expires on March 1, 2007. Amounts outstanding under the line bear interest
      at
      the bank’s reference rate (Wall Street Journal Prime Rate, which was 8.25% at
      June 30, 2006) plus 2.0%. The line of credit is collateralized by all accounts
      receivable and inventory, and is personally guaranteed by certain shareholders
      up to $375,000 (see Note 12). The Company had no borrowings under the line
      of
      credit at June 30, 2006.





**9.**  **Notes
      Payable**





Notes
      payable consist of the following at June 30, 2006 and 2005:


2006
              
              2005Tri-City
                  Industrial Development Council (TRIDEC) note payable (a)
              
              $
              10,000
              
              $
              20,000Benton-Franklin
                  Economic Development District (BFEDD) note payable (b)
              
              
              204,237
              
              
              222,693Columbia
                  River Bank note payable (c)
              
              
              -
              
              
              43,654Convertible
                  notes payable (d)
              
              
              -
              
              
              318,993Hanford
                  Area Economic Investment FundCommittee
                  (HAEIFC) note payable (e)
              
              
              418,671
              
              
              -632,908
              
              
              605,340Less
                  amounts due within one year
              
              
              (51,351
              )
              
              (43,116
              )Amounts
                  due after one year
              
              $
              581,557
              
              $
              562,224





(a)
            This
                is a non-interest bearing note, due in annual installments of $10,000,
                maturing August 2006. The note payable to TRIDEC bears no interest,
                but
                has not been discounted because the note was exchanged solely for
                cash.


(b)
            The
                note payable to BFEDD, which is collateralized by substantially all
                of the
                Company’s assets, and guaranteed by certain shareholders, was executed
                pursuant to a Development Loan Agreement. The note contains certain
                restrictive covenants relating to: working capital; levels of long-term
                debt to equity; incurrence of additional indebtedness; payment of
                compensation to officers and directors; and payment of dividends.
                The note
                is payable in monthly installments including interest at 8.0% per
                annum
                with a final balloon payment due in October 2009. At June 30, 2006,
                the
                Company was not in compliance with certain of the covenants. The
                Company
                has obtained a waiver from BFEDD, relating to these covenants, through
                June 30, 2007.


(c)
            During
                fiscal year 2006, the Company repaid the note payable to Columbia
                River
                Bank from cash on hand.


(d)
            The
                merger agreement between Medical, IsoRay (WA), and IsoRay Products
                LLC
                (see Note 1) provided the former note holders of IsoRay Products
                LLC with
                the option of exchanging their notes for IsoRay Medical, Inc. Series
                A
                preferred shares, or receiving IsoRay Medical, Inc. notes payable
                with
                substantially the same terms and conditions as their IsoRay Products
                LLC
                notes. None of the IsoRay Products LLC note holders elected to receive
                IsoRay Medical, Inc. Series A preferred shares. Accordingly, all
                the note
                holders (i.e., investors) were issued convertible notes. Note holders
                can
                convert principal and accrued interest on their outstanding balances
                into
                Series B preferred shares by exercising the warrants that were issued
                to
                them in connection with the merger (see Note 1). The notes accrued
                interest at 10%, which was paid quarterly, and were scheduled to
                mature in
                2006 and 2007. All of the notes were converted into preferred shares
                or
                repaid during 2006.


(e)
            In
                June 2006, the Company entered into a note payable with HAEIFC, which
                is
                collateralized by receivables, inventory, equipment, and certain
                life
                insurance policies. The total note payable facility is for $1.4 million
                and is to be used to purchase production equipment. In June 2006,
                the
                Company requested an initial disbursement of approximately $400,000.
                The
                note contains certain restrictive covenants relating to: financial
                ratios;
                payment of compensation to officers and directors; and payment of
                dividends. The note accrues interest at 9% and is payable in monthly
                installments with the final installment due in July
                2016.





F-14




On
      October 14, 2005, the Company borrowed $250,000 under a short-term note payable
      from a shareholder who was later appointed to the Board of Directors in April
      2006. The note, which bore interest at the rate of 10.0%, was paid in full
      on
      its due date of December 1, 2005. In connection with the loan, the Company
      granted a warrant to purchase 12,500 shares of common stock at an aggregate
      total exercise price of $10. The Company recorded financing expenses of $60,000
      related to the issuance of these warrants.





Principal
      maturities on notes payable are due as follows:


Year
                  ending June 30,2007
              
              $
              51,3512008
              
              
              49,0722009
              
              
              53,5932010
              
              
              179,0682011
              
              
              38,204Thereafter
              
              
              261,620$
              632,908


**10.**  **Capital
      Lease Obligations**





The
      Company leases certain equipment under long-term agreements that represent
      capital leases. Future minimum lease payments under capital lease obligations
      are as follows:


Year
                  ending June 30,2007
              
              $
              232,3362008
              
              
              215,0572009
              
              
              27,6272010
              
              
              -2011
              
              
              -Thereafter
              
              
              -Total
                  future minimum lease payments
              
              
              475,020Less
                  amounts representing interest
              
              
              (71,051
              )Present
                  value of net minimum lease payments
              
              
              403,969Less
                  amounts due in one year
              
              
              (183,554
              )Amounts
                  due after one year
              
              $
              220,415


**11.**  **Convertible
      Debentures Payable**





Through
      June 30, 2005, the Company had sold $3,587,875 of convertible debentures
      pursuant to the January 31, 2005 Offering (see Note 12). In July 2005, the
      Company sold an additional $550,000 of these convertible debentures. The
      debentures, which bear interest at 8% and mature two years from the date of
      issuance (through June 2007), can be converted into shares of the Company’s
      common stock at a rate of $4.15 per share plus, at the discretion of the
      Company, either a cash payment for accrued interest, or that number of common
      shares equal to the amount of unpaid accrued interest at $4.15 per
      share.





F-15




After
      the
      debentures had been outstanding for six months, the Company could, at its
      option, prepay them, in whole or in part, by paying the principal and interest
      accrued through the date of the prepayment. If only a portion of the debenture
      is prepaid, a new debenture with substantially the same terms and conditions
      will be issued to the debenture holder for the remaining principal
      balance.





On
      December 13, 2005, the Board of Directors announced a short-term conversion
      inducement to current holders of the convertible debentures, originally issued
      in conjunction with the January 31, 2005 Private Placement Offering. Holders
      were permitted two conversion options: 1) convert under the original terms
      of
      the debenture to the Company’s common stock at a $4.15 conversion price, and
      register the newly issued shares in the Form SB-2 Registration Statement filed
      with the SEC on November 10, 2005, or 2) convert under terms essentially
      identical to those offered to purchasers of Units in the Offering of October
      17,
      2005 - a $4.00 conversion price and one callable warrant to purchase one share
      of the Company's common stock at an exercise price of $6.00 per share for each
      share issued upon conversion (waiving registration rights for approximately
      one
      year). As of June 30, 2006, holders of $3,682,875 of debentures had converted
      to
      common stock of the Company, responding to the inducement of the second exercise
      method described above. As of June 30, 2006, the Company had issued 911,271
      shares of common stock (including approximately 23,840 incremental shares not
      previously available to holders of debentures under the original conversion
      terms), and 659,469 warrants to purchase shares of common, exercisable at $6.00
      per share. As of June 30, 2006, the Company recognized $385,511 in non-cash
      short-term inducement expense, in accordance with SFAS No. 84.





**12.**  **Shareholders’
      Equity (Deficit)**





The
      authorized capital structure of the Company consists of $.001 par value
      preferred stock and $.001 par value common stock.





Preferred
      Stock





The
      Company's Certificate of Incorporation authorizes 6,000,000 shares of $0.001
      par
      value preferred stock available for issuance with such rights and preferences,
      including liquidation, dividend, conversion and voting rights, as described
      below.





Series
      A





Series
      A
      preferred shares are entitled to a 10% dividend annually on the stated par
      value
      per share. These shares are convertible into shares of common stock at the
      rate
      of one share of common stock for each share of Series A preferred stock, and
      are
      subject to automatic conversion into common stock upon the closing of an
      underwritten public offering pursuant to an effective registration statement
      under the Securities Act of 1933 covering the offer and sale of common stock
      in
      which the gross proceeds to the Company are at least $4 million. Series A
      preferred shareholders have voting rights equal to the voting rights of common
      stock, except that the vote or written consent of a majority of the outstanding
      preferred shares is required for any changes to the Company’s Certificate of
      Incorporation, Bylaws or Certificate of Designation, or for any bankruptcy,
      insolvency, dissolution or liquidation of the Company. Upon liquidation of
      the
      Company, the Company’s assets are first distributed ratably to the Series A
      preferred shareholders. At June 30, 2006, there were no Series A preferred
      shares outstanding.





Series
      B





Series
      B
      preferred shares are entitled to a cumulative 15% dividend annually on the
      stated par value per share. These shares are convertible into shares of common
      stock at the rate of one share of common stock for each share of Series B
      preferred stock, and are subject to automatic conversion into common stock
      upon
      the closing of an underwritten public offering pursuant to an effective
      registration statement under the Securities Act of 1933 covering the offer
      and
      sale of common stock in which the gross proceeds to the Company are at least
      $4
      million. Series B preferred shareholders have voting rights equal to the voting
      rights of common stock, except that the vote or written consent of a majority
      of
      the outstanding preferred shares is required for any changes to the Company’s
      Certificate of Incorporation, Bylaws or Certificate of Designation, or for
      any
      bankruptcy, insolvency, dissolution or liquidation of the Company. Upon
      liquidation of the Company, the Company’s assets are first distributed ratably
      to the Series A preferred shareholders, then to the Series B preferred
      shareholders. At June 30, 2006, there were 144,759 Series B preferred shares
      outstanding and cumulative dividends in arrears were $39,356.





F-16




In
      addition to the shares of common stock and Series B preferred stock issued
      pursuant to the merger transaction (see Note 1), the Company had the following
      transactions that affected shareholders’ equity (deficit) during the years ended
      June 30, 2006 and 2005.





IsoRay,
      Inc. June 2006 Warrant Exercise Solicitation





In
      June
      2006, the Board of Directors approved a limited one-time discount of the
      exercise price of outstanding warrants (with exercise prices over $3.00) to
      $3.00 per share of common stock if the warrants were exercised on or before
      June
      30, 2006.  The warrants were primarily held by investors who purchased them
      as part of the Company’s October 2005 and February 2006 private placement
      offerings. The Company issued 427,764 common shares and raised $1,223,602,
      net
      of offering costs, through this warrant exercise solicitation.





IsoRay,
      Inc. February 2006 Private Placement





On
      February 1, 2006 the Company commenced an offering of Investment Units (“Units”)
      for sale, pursuant to a Private Placement Offering (the “February 2006
      Offering”), which management believes was exempt from registration under the
      Securities Act of 1933 ("the Act") pursuant to Section 4(2) of the Act and
      Rule
      506 of Regulation D. The February 2006 Offering consisted of a maximum of 89
      Units, each Unit consisting of 5,000 shares of common stock and a warrant to
      purchase 5,000 shares of common stock at an exercise price of $6.50 per share.
      The Units were sold for $22,500 per Unit. The Company closed this offering
      on
      February 24, 2006. Approximately $1.1 million, net of offering costs, was raised
      under the February 2006 Offering.





IsoRay,
      Inc. Subscriptions Receivable





On
      December 7, 2005, the Company entered into a SICAV ONE Securities Purchase
      Agreement and a SICAV TWO Securities Purchase Agreement (collectively, the
      "Purchase Agreements") with Mercatus & Partners, Limited, a United Kingdom
      private limited company ("Mercatus"). The Purchase Agreements permitted Mercatus
      to purchase 1,748,146 shares of the Company's common stock at a purchase price
      of $3.502 per share subject to receipt of funding. As no funding had been
      received, on May 18, 2006, the Company requested immediate return of the
      certificates representing all shares of common stock to which Mercatus had
      previously subscribed in accordance with the terms of the Purchase Agreements.
      The Purchase Agreements call for return of certificates within ten days if
      funding is not received within two days of receipt of the notice. After
      significant delay and the Company's attainment of a court order, the share
      certificates were returned. On August 8, 2006, the share certificates were
      cancelled and the Purchase Agreements were terminated (see Note
      17).





IsoRay,
      Inc. October 2005 Private Placement





On
      January 30, 2006 the Company closed an offering of Units for sale, pursuant
      to a
      Private Placement Offering (“the October 2005 Offering”) of October 17, 2005,
      which management believes was exempt from registration under the Securities
      Act
      of 1933 ("the Act") pursuant to Section 4(2) of the Act and Rule 506 of
      Regulation D. The October 2005 Offering consisted of a maximum of 200 Units,
      each Unit consisting of 5,000 shares of common stock and a warrant to purchase
      5,000 shares of common stock at an exercise price of $6.00 per share. This
      maximum was increased, pursuant to the terms of the October 2005 Offering,
      at
      the sole discretion of the Company, to a maximum of 300 Units. The Units were
      sold for $20,000 per Unit. Approximately $5.4 million, net of offering costs,
      was raised under the October 2005 Offering.





F-17




IsoRay
      Medical, Inc. January 2005 Private Placement





In
      January 2005, Medical commenced an offering (“the January 2005 Offering”) of up
      to $2,000,000 of 8% convertible debentures (see Note 11) to accredited investors
      in a private placement, which management believes was exempt from registration
      under the Securities Act of 1933 ("the Act") pursuant to Section 4(2) of the
      Act
      and Rule 506 of Regulation D. On May 27, 2005, Medical amended and restated
      the
      January 2005 Offering to increase the maximum amount of the offering to
      $4,150,000.





Through
      June 30, 2005, Medical sold debentures totaling $3,587,875. In connection with
      the sales of these debentures, Medical paid commissions totaling $216,783 and
      legal expenses totaling $56,470, which amounts have been recorded as deferred
      financing costs.





In
      July
      2005, Medical sold an additional $550,000 of debentures pursuant to this
      offering. The sale of these additional debentures was not subject to payment
      of
      commissions.





In
      2006,
      $3,682,875 of the debentures were converted to common stock pursuant to a
      short-term conversion inducement (see Note 11).





IsoRay
      Medical, Inc. October 2004 Private Placement





In
      October 2004, Medical commenced an offering (“the October 2004 Offering”) of up
      to $2,000,000 of securities to accredited investors in a private placement,
      which management believes was exempt from registration under the Securities
      Act
      of 1933 ("the Act") pursuant to Section 4(2) of the Act and Rule 506 of
      Regulation D. The October 2004 Offering consisted of up to 100 Investment Units,
      each unit consisting of 10,000 shares of Medical’s common stock and a callable
      warrant to purchase 3,000 shares of common stock at an exercise price of $.50
      per share, for $20,000 per Investment Unit. Simultaneous with the October 2004
      Offering, the officers and directors of Medical had the right to independently
      sell similar Investment Units pursuant to a separate private placement
      memorandum on substantially the same terms and conditions as the October 2004
      Offering.





During
      the year ended June 30, 2005, Medical sold 76.55 Investment Units, representing
      765,500 common shares and callable warrants for the purchase of 229,650 common
      shares, for cash totaling $1,531,000. In connection with the sales of the
      Investment Units, Medical paid commissions and expense allowances totaling
      $119,980 to broker-dealers, and legal expenses totaling $54,442 to attorneys,
      which amounts have been recorded as reductions of additional paid-in
      capital.





In
      connection with the October 2004 Offering, Medical granted the selling
      broker-dealers warrants to purchase 4.23 Investment Units at $20,000 per
      Investment Unit. These Investment Units, which expire on March 25, 2007,
      represent 42,300 IsoRay Medical, Inc. common shares and 12,690 warrants to
      purchase common shares at $.50 per share.





Issuance
      of Common Stock for Guarantee of Debt





During
      fiscal year 2005, Medical issued 211,140 shares of its common stock to certain
      shareholders as an inducement for their guarantee of the Columbia River Bank
      line of credit (see Note 8) and the note payable to Benton-Franklin Economic
      Development District (see Note 9). The transactions were recorded at the fair
      value of the shares, estimated to be $348,381, since management considered
      this
      amount to be more readily determinable than the value of the guarantees. The
      guarantees were recorded as deferred financing costs (see Note 2).




F-18


Issuance
      of Common Stock in Payment of Consulting Services





During
      2006, the Company issued 173,472 shares of its common stock in full satisfaction
      of consulting services including 168,472 shares that were issued as payment
      for
      merger consulting services (see Note 1). The shares were valued using the market
      price of the stock on the date of issue.





Issuance
      of Common Stock in Partial Payment of Equipment Purchase





During
      2006, the Company issued 10,000 shares of its common stock and paid $962 of
      cash
      in full satisfaction for the purchase of production equipment and repairs and
      maintenance invoices totaling $40,962. The shares were valued using the market
      price of the stock on the date of issue.





During
      2005, Medical issued 30,303 shares of its common stock and paid $40,000 of
      cash
      in full satisfaction of the $90,000 purchase price of three laser welding
      stations. The transaction was recorded at the purchase price of the laser
      welding stations, since management considered this amount to be more readily
      determinable than the fair value of the shares.





Cash
      Payments for Fractional Shares





During
      2006, the Company paid a combined total of $734 to the former common and
      preferred shareholders of Medical and Century for fractional shares that
      resulted from the merger that was effective July 28, 2005 (see Note
      1).





During
      2005, Medical paid a combined total of $100 to the former common shareholders
      of
      IsoRay, Inc. (WA) and the former Class A, B and C members of IsoRay Products
      LLC
      for fractional shares that resulted from the merger that was effective October
      1, 2004 (see Note 1).




Warrants
      to Purchase Series B Preferred Stock





Pursuant
      to a private placement of debt units during 2003 and 2004, IsoRay Products
      LLC
      issued $365,000 of notes payable to investors (see Note 9) and granted warrants
      for the purchase of 227,750 of its Class A member shares. In connection with
      the
      merger transaction of IsoRay (WA) and IsoRay Products LLC into IsoRay Medical,
      Inc. (see Note 1), Medical exchanged the IsoRay Products LLC warrants for
      warrants to purchase 384,440 IsoRay Medical, Inc. Series B preferred shares.
      The
      warrants activity is summarized as follows:


2006
                  (a)
              
              2005
                  (a)Warrants
              
              Price
                  (b)
              
              Warrants
              
              Price
                  (b)Beginning
                  balance outstanding
              
              
              233,008
              
              $
              0.84
              
              
              323,830
              
              $
              0.91Exercised
              
              
              (53,496
              )
              
              1.03
              
              
              (90,822
              )
              
              1.07Ending
                  balance outstanding
              
              
              179,512
              
              $
              0.79
              
              
              233,008
              
              $
              0.84





(a)
            2005
                share and price data and 2006 beginning balances have been adjusted
                to
                reflect the 0.842362 conversion ratio (see Note
                1).


(b)
            Weighted
                average price per share.




F-19


The
      following table summarizes additional information about the Company’s preferred
      warrants outstanding as of June 30, 2006:


Number
                  of Warrants
              
              Price
              
              Expiration
                  Date56,876
              
              $
              0.70
              
              
              October
                  30, 200628,438
              
              
              0.70
              
              
              January
                  31, 200731,102
              
              
              1.06
              
              
              February
                  28, 20076,220
              
              
              1.40
              
              
              February
                  28, 200756,876
              
              
              0.70
              
              
              March
                  30, 2007179,512


Warrants
      to Purchase Common Stock





In
      connection with the February 2006 Offering, the October 2005 Offering, the
      October 2004 Offering, and at other times the Company has issued warrants for
      the purchase of common stock. The warrants activity is summarized as
      follows:


2006
                  (a)
              
              2005
                  (a)Warrants
              
              Price
                  (b)
              
              Warrants
              
              Price
                  (b)Beginning
                  balance outstanding
              
              
              136,158
              
              $
              1.20
              
              
              -
              
              $
              -Warrants
                  issued
              
              
              2,878,522
              
              
              5.85
              
              
              245,454
              
              
              0.93Exercised
              
              
              (511,911
              )
              
              2.49
              
              
              (109,296
              )
              
              0.59Ending
                  balance outstanding
              
              
              2,502,769
              
              $
              5.73
              
              
              136,158
              
              $
              1.20





(a)
            2005
                share and price data and 2006 beginning balances have been adjusted
                to
                reflect the 0.842362 conversion ratio (see Note
                1).


(b)
            Weighted
                average price per share.





The
      following table summarizes additional information about the Company’s common
      warrants outstanding as of June 30, 2006:


Number
                  of Warrants
              
              Range
                  of Exercise Prices
              
              Expiration
                  Date19,500
              
              $
              6.00
              
              
              January
                  20072,488
              
              $
              1.06
              
              
              February
                  200746,419
              
              $
              0.59
                  to $2.37
              
              
              March
                  2007277,616
              
              $
              4.15
              
              
              July
                  200712,500
              
              $
              0.0008
              
              
              October
                  200753,000
              
              $
              6.00
              
              
              October
                  2007162,500
              
              $
              6.00
              
              
              November
                  2007935,382
              
              $
              5.75
                  to $6.00
              
              
              December
                  2007680,750
              
              $
              6.00
              
              
              January
                  2008281,923
              
              $
              6,00
                  to $6,50
              
              
              February
                  20085,691
              
              $
              4.15
              
              
              March
                  200825,000
              
              $
              2.00
              
              
              July
                  20152,502,769


Common
      Stock Option Plans





On
      July
      28, 2005, the Company adopted the Amended and Restated 2005 Stock Option Plan
      (the "Option Plan") and the Amended and Restated 2005 Employee Stock Option
      Plan
      (the "Employee Plan"), pursuant to which it may grant equity awards to eligible
      persons. The Option Plan allows the Board of Directors to grant options to
      purchase up to 1,800,000 shares of common stock to directors, officers, key
      employees and service providers of the Company, and the Employee Plan allows
      the
      Board of Directors to grant options to purchase up to 2,000,000 shares of common
      stock to officers and key employees of the Company. These options can be granted
      with various vesting schedules and have a maximum term of 10 years.





F-20




These
      plans replaced the IsoRay Medical, Inc. 2004 Stock Option Plan (“the 2004 Plan”)
      and the IsoRay Medical, Inc. 2004 Employee Stock Option Plan (“the 2004 Employee
      Plan”). The stated purpose of the plans was to provide an incentive-based form
      of compensation to directors, officers, key employees and service providers
      of
      Medical and encourage such persons to invest in shares of Medical’s common
      stock, thereby acquiring a proprietary interest in the success of
      Medical.





Replacement
      options were issued from the Option Plan and the Employee Plan to replace those
      options previously granted under the 2004 Plan and the 2004 Employee Plan.
      The
      replacement options are included in the totals show below for options granted
      and outstanding pursuant to the Option Plan and the Employee Plan.





Stock-Based
      Compensation





As
      described in Note 2, the Company currently accounts for stock-based compensation
      in accordance with SFAS No. 123. As permitted by SFAS No. 123, management
      currently accounts for share-based payments to employees using APB 25's
      intrinsic value method, and provides expanded footnote disclosure when
      necessary.





In
      December 2004, the Financial Accounting Standards Board issued SFAS No. 123
      (revised 2004), *Share-Based
      Payment* ("SFAS
      No. 123(R)"), which is a revision of SFAS No. 123. SFAS No. 123(R) also
      supersedes APB 25, and amends SFAS No. 95, *Statement
      of Cash Flows* .
      Generally, the approach in SFAS No. 123(R) is similar to the approach prescribed
      by SFAS No. 123. SFAS No. 123(R) requires that all share-based payments to
      employees, including grants of employee stock options, be recognized in the
      income statement based on their fair values. Pro forma disclosure will no longer
      be permitted. SFAS No. 123(R) is effective at the beginning of the first fiscal
      year beginning after December 15, 2005. The Company plans to adopt
      SFAS 123(R) on July 1, 2006 on a prospective basis. Upon adoption, all
      future employee stock option grants plus the balance of the non-vested grants
      awarded prior to July 1, 2006, will be expensed over the stock option
      vesting period based on the fair value at the date the options are granted.
      The
      Company estimates that the impact of adoption will be an additional expense
      of
      $189,430 for employee stock options granted prior to June 30, 2006.





A
      summary
      of the Company’s stock option activity and related information for the years
      ended June 30, 2006 and 2005 is as follows:


2006
                  (a)
              
              2005
                  (a)Shares
              
              Price
                  (b)
              
              Shares
              
              Price
                  (b)Beginning
                  balance outstanding
              
              
              2,237,802
              
              $
              1.31
              
              
              383,430
              
              $
              1.19Granted
                  (c)
              
              
              1,189,722
              
              
              3.23
              
              
              1,962,703
              
              
              1.33Cancelled
              
              
              (196,548
              )
              
              1.19
              
              
              -
              
              
              -Exercised
              
              
              (101,284
              )
              
              1.18
              
              
              (108,331
              )
              
              1.19Ending
                  balance outstanding
              
              
              3,129,692
              
              $
              2.05
              
              
              2,237,802
              
              $
              1.31Exercisable
                  at end of year
              
              
              2,649,576
              
              $
              1.79




(a)
            2005
                share and price data and 2006 beginning balances have been adjusted
                to
                reflect the 0.842362 conversion ratio (see Note
                1).


(b)
            Weighted
                average price per share.


(c)
            All
                options granted had exercise prices equal to the ending market price
                of
                the Company’s common stock on the grant
                date.





F-21




The
      following table summarizes additional information about the Company’s stock
      options outstanding as of June 30, 2006:


Options
                  Outstanding
              
              Options
                  ExercisableRange
                  of Exercise Prices
              
              Shares
              
              Price
                  (a)
              
              Life
                  (b)
              
              Shares
              
              Price
                  (a)$1.00
                  to $1.19
              
              
              1,886,179
              
              $
              1.16
              
              
              8.97
                  yrs
              
              
              1,717,707
              
              $
              1.16$1.96
                  to $2.00
              
              
              653,791
              
              
              1.98
              
              
              9.09
                  yrs
              
              
              653,791
              
              
              1.98$3.80
                  to $4.15
              
              
              318,472
              
              
              3.99
              
              
              9.49
                  yrs
              
              
              128,078
              
              
              3.88$5.50
                  to $6.55
              
              
              271,250
              
              
              6.15
              
              
              9.64
                  yrs
              
              
              150,000
              
              
              6.38Total
                  options
              
              
              3,129,692
              
              
              
              
              
              
              
              
              2,649,576





(a)
            Weighted
                average exercise price.


(b)
            Weighted
                average remaining contractual life.





The
      pro
      forma net loss presented below for the years ended June 30, 2006 and 2005 was
      determined as if the Company had accounted for these options under the fair
      value method of SFAS No. 123. The fair value of these options was estimated
      at
      the date of grant using the Black-Scholes method set forth in SFAS No.
      123(R).


2006
              
              2005Net
                  loss as reported
              
              $
              8,218,130
              
              $
              4,269,188SFAS
                  No. 123 stock option expense
              
              
              1,167,086
              
              
              771,365Pro
                  forma net loss
              
              $
              9,385,216
              
              $
              5,040,553Net
                  loss per share:Basic,
                  as reported
              
              $
              0.68
              
              $
              0.78Basic,
                  pro forma
              
              
              0.77
              
              
              0.92Diluted,
                  as reported
              
              
              0.68
              
              
              0.78Diluted,
                  pro forma
              
              
              0.77
              
              
              0.92


The
      following assumptions were used in calculating the fair value of the
      options:


2006
              
              2005Weighted
                  average risk-free interest rate
              
              
              4.67
              %
              
              3.50
              %Expected
                  life of the option (in years)
              
              
              7.31
              
              
              10.00Expected
                  price volatility
              
              
              31.24
              %
              
              30.00
              %Expected
                  dividend yield
              
              
              0.00
              %
              
              0.00
              %




If
      the
      Company had fully accounted for its employee stock options in accordance with
      the provisions of SFAS No. 123, compensation expense would have been $1,167,086
      and $771,365 greater than the amounts recorded for the years ended June 30,
      2006
      and 2005, respectively.




**13.**  **Income
      Taxes**





The
      Company recorded no income tax provision or benefit for the years ended June
      30,
      2006 and 2005.





At
      June
      30, 2006, the Company had a net deferred tax asset of approximately $3,820,000,
      arising principally from net operating loss carryforwards. The deferred tax
      asset was calculated based on the currently enacted 34% statutory income tax
      rate. Since management of the Company cannot determine if it is more likely
      than
      not that the Company will realize the benefit of its net deferred tax asset,
      a
      valuation allowance equal to the full amount of the net deferred tax asset
      at
      June 30, 2006 has been established.





F-22




At
      June
      30, 2006, the Company had tax basis net operating loss carryforwards of
      approximately $11,000,000 available to offset future regular taxable income.
      These net operating loss carryforwards expire through 2026.





IsoRay
      Products LLC was a limited liability company prior to the merger with Medical.
      In lieu of current federal income taxes arising at the company level, the
      individual members were taxed on their proportionate share of the company’s
      taxable income. Accordingly, there are no net operating loss carryforwards
      related to this entity.





**14.**  **Related
      Party Transactions**





In
      addition to transactions described in Note 12, the Company had the following
      transactions with related parties:





The
      Company received various legal services from two law firms in which one of
      the
      firm’s partners is a member of the Company’s Board of Directors. The total
      amounts paid in 2006 and 2005 to the law firms were $390,000 and $285,000,
      respectively. The 2006 expenses include approximately $77,000 accrued in
      accounts payable as of June 30, 2006.





During
      fiscal year 2006, the Company paid $60,000 to a shareholder for strategic
      business and financial consulting.





During
      2005, Medical paid or accrued $5,600 for accounting services performed by a
      company owned by a member of Medical’s Board of Directors.





**15.**  **Commitments
      and Contingencies**





Royalty
      Agreement for Invention and Patent Application





A
      shareholder of the Company previously assigned his rights, title and interest
      in
      an invention to IsoRay Products LLC in exchange for a royalty equal to 1% of
      the
      Gross Profit, as defined, from the sale of “seeds” incorporating the technology.
      The patent and associated royalty obligations were transferred to the Company
      in
      connection with the merger transactions (see Note 1).





The
      Company must also pay a royalty of 2% of Gross Sales, as defined, for any
      sub-assignments of the aforesaid patented process to any third parties. The
      royalty agreement will remain in force until the expiration of the patents
      on
      the assigned technology, unless earlier terminated in accordance with the terms
      of the underlying agreement. To date, there have been no product sales
      incorporating the technology and there is no royalty due pursuant to the terms
      of the agreement.





Patent
      and Know-How Royalty License Agreement





IsoRay
      Products LLC was the holder of an exclusive license to use certain “know-how.”
This license was transferred to Medical and subsequently to the Company in
      connection with the merger transactions (see Note 1). The terms of the original
      license agreement required the payment of a royalty based on the Net Factory
      Sales Price, as defined in the agreement, of licensed product sales. Because
      the
      licensor’s patent application was ultimately abandoned, only a 1% “know-how”
royalty based on Net Factory Sales Price, as defined, remains applicable. To
      date, there have been no product sales incorporating the licensed technology
      and
      there is no royalty due pursuant to the terms of the agreement. Management
      does
      not believe that it will ever incorporate this technology in its products and
      therefore that no royalty payment will be due.





F-23


Battelle
      Memorial Institute Production Agreement





In
      April
      2004, IsoRay Products LLC entered into an agreement with Battelle Memorial
      Institute, Pacific Northwest Division (Battelle), the operator of the Pacific
      Northwest National Laboratory, for certain production-related services and
      facilities. This agreement was assumed by Medical and subsequently by the
      Company following the merger transactions (see Note 1). In accordance with
      the
      terms of the agreement, the Company is required to make advance payments, which
      are then applied against billings by Battelle as services are provided. During
      the years ended June 30, 2006 and 2005, the Company incurred $868,650 and
      $574,225, respectively, of costs for production-related services and facilities
      provided by Battelle. At June 30, 2006, prepaid expenses include $7,913 related
      to this agreement. The agreement, which expires December 31, 2007, may be
      terminated at any time by either party, upon giving a 60-day written notice
      to
      the other party.





Operating
      Lease Agreements





The
      Company leases office and laboratory space and production and office equipment
      under noncancelable operating leases. The lease agreements require monthly
      lease
      payments and expire on various dates through June 2011. Future minimum lease
      payments under operating leases are as follows:


Year
                  ending June 30,2007
              
              $
              45,4432008
              
              
              13,3692009
              
              
              9,7472010
              
              
              9,6042011
              
              
              9,175Thereafter
              
              
              -$
              87,338





In
      February 2005, the Company entered into a lease agreement for a portion of
      a
      building in which it established production facilities. The lease term commenced
      on regulatory licensing approval, which was obtained in October 2005, and
      terminates one year from the commencement date of the lease. The annual rental
      was paid using 24,007 shares of the Company’s common stock. Rent expense of
      $90,026 has been recognized in the year ended June 30, 2006 relating to this
      facility.





Rental
      expense (including rent paid with common stock) amounted to $155,838 and $28,641
      for the years ended June 30, 2006 and 2005, respectively.





License
      Agreement with IBt





In
      February 2006, the Company signed a license agreement with International
      Brachytherapy s.a. (“IBt”) covering North America and providing the Company with
      access to IBt’s Ink Jet production process and its proprietary polymer seed
      technology for use in brachytherapy procedures using Cesium-131. The Company
      paid license fees of $275,000 during 2006 and another payment of $225,000 was
      to
      be made in August 2006 pursuant to the license agreement. Royalty payments
      based
      on net sales revenue incorporating the technology are also required, with
      minimum quarterly royalties ranging from $100,000 to $200,000 and minimum annual
      royalties ranging from $400,000 to $800,000 over the term of the
      agreement.





As
      of the
      date of this report, the August 2006 payment has not been made as the Company
      has been in continued negotiations with IBt concerning the amount and timing
      of
      future royalty payments due to the low market acceptance of the polymer seed
      technology.


F-24


**16.**  **Concentrations
      of Credit and Other Risks**





Financial
      Instruments





The
      Company’s financial instruments that are exposed to concentrations of credit
      risk consist primarily of cash and cash equivalents and accounts
      receivable.





The
      Company’s cash and cash equivalents are maintained with high-quality financial
      institutions. The accounts are guaranteed by the Federal Deposit Insurance
      Corporation (FDIC) up to $100,000. At June 30, 2006, uninsured cash balances
      totaled $1,726,445.





The
      Company’s accounts receivable result from credit sales to customers. The Company
      had three customers whose sales were greater than 10% for each of the years
      ended June 30, 2006 and 2005. These customers represented 49.15% and 70.93%
      of
      the Company’s total revenues for the years ended June 30, 2006 and 2005,
      respectively. Those same customers accounted for 47.9% and 77.5% of the
      Company’s net accounts receivable balance at June 30, 2006 and 2005,
      respectively.





Sales
      to
      the Company’s largest customer totaled 20.6% and 30.6% of total revenues in 2006
      and 2005, respectively.





The
      loss
      of any of these significant customers would have a temporary adverse effect
      on
      the Company’s revenues, which would continue until the Company located new
      customers to replace them.





The
      Company routinely assesses the financial strength of its customers and provides
      an allowance for doubtful accounts as necessary.





Inventories





Most
      components used in the Company’s product are purchased from outside sources.
      Certain components are purchased from single suppliers. The failure of any
      such
      supplier to meet its commitment on schedule could have a material adverse effect
      on the Company’s business, operating results and financial condition. If a
      sole-source supplier were to go out of business or otherwise become unable
      to
      meet its supply commitments, the process of locating and qualifying alternate
      sources could require up to several months, during which time the Company’s
      production could be delayed. Such delays could have a material adverse effect
      on
      the Company’s business, operating results and financial condition.





**17.**  **Subsequent
      Events**





The
      following events and transactions have occurred subsequent to June 30,
      2006:





Return
      of Subscription Receivable Shares





The
      Company had previously entered into Purchase Agreements with Mercatus in
      December 2005 that permitted Mercatus to purchase 1,748,146 shares of common
      stock subject to the receipt of funding (see Note 12). As no funding had been
      received, on May 18, 2006, the Company requested the return of the share
      certificates. After significant delay and the Company’s attainment of a court
      order, the share certificates were returned. On August 8, 2006, the share
      certificates were cancelled and the Purchase Agreements were
      terminated.





August
      2006 Stock Purchase Agreement





On
      August
      17, 2006, the Company sold certain shares of its common stock and warrants
      to
      purchase common stock pursuant to a Common Stock and Warrant Purchase Agreement
      (the "Purchase Agreement") dated August 9, 2006. The securities were issued
      to
      25 accredited investors pursuant to the exemption from registration provided
      by
      Section 4(2) of the Securities Act of 1933, as amended. MicroCapital, LLC acted
      as the lead investor for the transaction. A total of $5,158,000 in cash proceeds
      (less 6% commissions to registered broker-dealers and other legal costs) was
      received by the Company in exchange for the issuance of 2,063,200 shares of
      common stock and warrants to purchase 2,063,200 shares of common stock. In
      addition, brokers assisting the Company with the capital raise were issued
      warrants to purchase 206,300 shares of common stock on identical terms as the
      warrants issued to investors. If all warrants were exercised, the Company would
      receive $6,808,500.





F-25




Pursuant
      to the Purchase Agreement, the purchase price per share of the Company’s common
      stock was $2.50, and the accompanying warrants were issued with an exercise
      price of $3.00 per share. The warrants and the Purchase Agreement contain
      anti-dilution provisions, including one providing that, if the Company issues
      stock or rights to acquire stock at a price less than $2.00 (excluding certain
      issuances such as options to employees, directors and certain consultants and
      shares issued in connection with licensing or leasing transactions), the Company
      is required to issue to each investor additional shares equal to 25% of what
      such investor purchased in the original transaction. The warrants are
      exercisable by the holder (subject to anti-dilution and adjustment provisions)
      for a period of five years from the date of issuance. The warrants are callable
      by the Company for 45 days after a period of 60 trading days in which the price
      of the underlying stock exceeds $4.50 per share for 30 of the 60 days, and
      only
      if a registration statement covering the underlying shares is
      effective.





In
      connection with the Purchase Agreement, the Company also entered into a
      Registration Rights Agreement whereby the Company has agreed to file a
      registration statement to cover the re-sale of the shares of common stock sold
      and issuable upon exercise of the warrants. Under the Registration Rights
      Agreement, the Company has agreed to file the registration statement within
      60
      days of the closing, cure any defect causing the registration statement to
      fail
      to be effective within 10 business days, and cause suspension periods for the
      registration statement to not exceed 60 days in any 360 day period. If the
      Company fails to comply with these provisions, the Company will be required
      to
      pay as liquidated damages an amount equal to 2% of the aggregate purchase price
      paid by the investors for each 30 day period during which the failure continues,
      not to exceed 10% of the aggregate purchase price.





Settlement
      Agreements with Former Executives





In
      September 2006, the Company entered into a settlement agreement with a former
      executive. As part of the settlement the Company agreed to pay the former
      executive $100,000 in September 2006 and $215,000 in January 2007. As the former
      executive’s employment with the Company ended in March 2006, the full amount of
      both payments was accrued as of June 30, 2006 in accrued payroll.





Also
      in
      September 2006, the Company reached a preliminary settlement agreement with
      its
      former Chief Financial Officer. The preliminary settlement calls for payments
      totaling $288,000 through September 2007. As the former Chief Financial
      Officer’s employment ended in September 2006, no accrual was made as of June 30,
      2006.


F-26


SIGNATURES





In
      accordance with the requirements of the Exchange Act, the Company caused this
      report to be signed on its behalf by the undersigned, thereunto duly
      authorized.





Dated:
      September 28, 2006




ISORAY,
              INC., a
              Minnesota corporationBy
            /s/ Roger
              E.
              GirardRoger
              E. Girard, Chief Executive
              Officer


By
            /s/ Jonathan
              R. HuntJonathan
              R. Hunt, Chief Financial Officer